A knack for understanding mutual fund performance can help investors make better decisions and get returns
Even though the past performance of a mutual fund may not be a guarantee of future results, but a knack for understanding mutual fund performance can help investors make better decisions if they are able to pick and avoid funds based on observation and smart analysis. Here are some measures that they must keep in mind in order to make informed decisions.
Use a benchmark to compare fund performance: Any return or result doesn’t have a value unless it is compared to a benchmark. A score of 75 for a school student has no relevance if it is not compared with the highest scorer. Similarly, any mutual fund performance has to be compared with a benchmark. However, comparison should be done using a fair and appropriate benchmark. Using the wrong yardstick will only give misleading data. For example, the performance of any small-cap mutual fund cannot be compared with a broad-based index like Nifty 500. Instead the benchmark, in this case, should be the small-cap index, like S&P BSE Small Cap TRI. If the fund has delivered higher returns consistently, then it’s a good fund to invest in.
Analyse fund history: The longer the history of the fund, the better it is as a history of five to ten years would have borne the brunt of market vagaries. It would be a better candidate for comparing performance across different time intervals and business cycles. The real mettle of a fund can be observed in a market downturn and if it gives even an average performance it should be added to the portfolio.
Understand the expenses: According to the Securities and Exchange Board of India (SEBI) guidelines, expense ratio should not be more than 2.5 per cent of the fund’s average asset under management (AUM). So, understanding the expense ratio before investing in a mutual fund is absolutely important. Since, expense ratios are charged out of fund returns, higher the expense ratio, lower the returns. Always look for a fund which offers similar returns at a relatively lower expense ratio. The same mutual fund is available as a direct plan and a regular plan. Direct plans of mutual funds come at a lower expense ratio; which translates into higher returns. Also, investing in direct plans can save you loads on commissions as against investment in a regular plan.
Returns must be compared to the risk taken: Returns should never be taken singularly. They must always be adjusted for risk taken by the mutual fund to generate that return. The risk is measured with the help of standard deviation. Using Sharpe ratio helps to ascertain whether the fund is giving higher returns on every additional unit of risk taken. A fund with a Sharpe ratio higher than the category average shows that the fund manager delivered higher returns for the extra risk taken.
Give weightage to fund performance: Common time periods for mutual fund performance available to investors include one-year, three-year, five-year and ten-year returns. An investor can create an evaluation system based upon percentage weights. If weightage of 40 per cent is given to the five-year period, 30 per cent to the ten-year period, 20 per cent to the three-year period and 10 per cent to the one-year period, then one can multiply the percentage weights by each corresponding return for the given time periods and average the totals. This can then be used to compare funds to each other.
Don’t forget the Alphas and the Betas: Alpha measures excess returns generated by the fund when compared to the benchmark. On the other hand, Beta measures the riskiness of a fund. If the Beta value is more than one, it shows that the fund gains more than the benchmark on an upturn and loses more than the benchmark in case of a downturn. A Beta value of one indicates that the mutual fund’s returns move the same as the benchmark. If the Beta is less than one, then the fund gains less than the benchmark during a rally and loses less than the benchmark on a downward spiral.
Keep in mind the Portfolio Turnover Ratio: The Portfolio Turnover Ratio (PTR) tells you how often the fund manager buys/sells securities in the portfolio. In case of equity funds, it shows the level of trading taking place in the fund, which in turn attracts transaction charges like the brokerage. Frequent trading could ultimately increase the expenses and is reflected as a higher expense ratio, thereby reducing the returns of the fund. Therefore, while choosing a fund, look for one with a lower PTR.
Although these are not foolproof guidelines, they are important factors that can help any investor make smart decisions about buying the best mutual funds for his/her portfolio depending upon the risk appetite.
(The writer is Assistant Professor, Amity University)