How to choose a good mutual fund

One line answer: select any 5 star or 4 star fund from www.valueresearchonline.com.

Long answer: look at the track record of various mutual funds, monitor how have they performed over the period of time and how the performance has been lately. Check out couple of ratios and bingo!

Let's take HDFC Top 200 (this is my personal favourite fund) : (All these screen shots are from valueresearchonline.com)

I have highlighted the important aspects:

1. It is 5 star fund
2. Its return grade is high and risk grade is below average
3. Trailing returns for 1 year is 32%, for 3 years (compounded annually) is 17.30 (due to 2008-09), for 5 years it is 26.67 (stupendous) and from launch it has been 26.71 (fantastically stupendous).

Now if we go to Performance tab the scene is as following:

This image has couple of important points. Fund returns with respect to category return, with respect to Nifty and with respect to Sensex.

There are other ratios:

1. R-Squared ratio: is the statistical measure of how well an approximation (regression) line matches with the real data points. It is an analysis of the deviation from the benchmark. For equity funds, the benchmark is Nifty or Sensex. This ratio varies from 0 to 1. 0 says there is no correlation while 1 says there is 100% correlation. This mutual fund's R Squared is .96, which means it is closely tied to the fluctuations/returns in the Sensex.
2. Alpha ratio: tells how better a security has been against the bench mark. Alpha of 9.41 says that this mutual fund has been outperforming the benchmark Sensex by 9.41%.
3. Beta ratio: talks about the volatility of a security as compared to the benchmark. If the beta value is more than 1, the NAV of that fund will fluctuate more than the benchmark. If the beta is 1, it will go along with Sensex. If the beta value is less than 1, it means the security is not much volatile and safe. This fund comes into this category.
4. Standard deviation: is another measure of volatility in the fund. It is calculated on the historical annual rate of return data. It is a measure of how the funds performance deviates from the average performance over a period. A low standard deviation is better. This fund apparantly has it little higher side, but this is due the recession (and jump back after that) effect.
5. Sharpe ratio: is one of the most important ratios for risk analysis of a fund. This ratio also throws light on the fact that the fund's performance was just a fluke or due to a smart fund manager. Sharpe ratio gives a sense of returns from a fund over the risk less return per unit of risk. Risk here is the standard deviation. The higher Sharpe ratio, the better it is. But it all alone doesn't guarantee any information. It is calculated as ((expected return - risk free return)/standard deviation). If the standard deviation is very low (for liquid funds) the Sharpe ratio could come very high but that doesn't guarantee higher returns.

Other tabs are self explanatory and can be easily understood.
In the next post I shall provide a list of 2010's good equity mutual funds and their ratio analysis.

So what is my conclusion here?
Always look at the risk side of your investments. Don't distribute your hard earned money to agents.

Disclaimer: I am not advocating anyone to buy HDFC Top 200. This is my personal faviourite mutual fund. I have selected it based on my risk profile and objectives from investing.