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Evaluate mutual funds in a holistic manner

Rahul is a young mutual fund investor with high risk tolerance and decent income. He has several goals. He comes across mutual funds that have delivered superlative returns in recent times and he decides to invest in them. Though returns are important, they should not be the only criteria for selecting funds. Instead, Rahul should adopt a holistic approach and evaluate factors such as the risk and cost involved, consistency of the fund’s performance, ability to give high risk-adjusted returns, portfolio composition and pedigree of the fund house. He can make use of the mutual fund literature available in the public domain (fund factsheet and other scheme-related documents) or take the help of a financial professional.

Every investor dreams of investing in a fund which yields handsome returns. Typically, investors’ choice is guided by returns. However, good historical performance does not guarantee the same in the future. Investors should adopt a holistic approach and evaluate factors such as the risk and cost involved, consistency of the fund’s performance, ability to give high risk-adjusted returns, portfolio composition and pedigree of the fund house.

Chart 1

  1. Consistent performance is more crucial than the recent show

One of the common yardsticks to measure a fund’s performance is its recent performance (six months or one year). While this is an easy approach, it may not be rewarding because recent outperformance could be a result of higher risk taken by the fund manager or just coincidence. Instead, look at consistency. The fund should consistently perform better than the benchmark and peers across market phases. Investors can consider long terms such as three, five or seven years to gauge consistency.

2. Risk

Mutual funds are market linked and their performance varies based on changes in the underlying asset classes – primarily equity and debt. Risk, too, varies across schemes. Some of the key risk factors in equity and debt funds are listed below:

Chart 2

  • Equity funds invest in the equity and equity-related instruments and are exposed to the following risks:
  1. Market risk – Equity funds invest in equities and related instruments, and are exposed to market volatility. Diversification across stocks and sectors, and the fund manager’s ability to churn the portfolio in line with market movements can help limit the downside.
  2. Company-specific risk – Equity funds invest in companies across market capitalisation (large, small and mid-cap). Typically, small and mid-cap companies are more sensitive to the business or economic downturn than large caps which are more stable. Funds with exposure to smaller companies that are not so well established are subjected to greater company-specific risk.
  3. Macroeconomic risk – Equity market performance is influenced by macroeconomic cues such as economic growth, inflation, fiscal deficit and interest rate. Global developments, too, have a bearing on domestic equities and all of these, in turn, impact equity funds. The influence of global cues is intensified in case of global funds or country-specific funds.
  4. Liquidity risk – This risk emits from lower trading volume of the stock which could make the exit difficult. This is greater in case of penny stocks (extremely low value).
  5. Concentration risk – Sector or thematic funds have higher concentration risk as investment caters to a particular sector or theme. Though it increases the potential for returns, it carries greater risk (than all other funds) in case of unfavourable developments in a sector.
  • Debt funds invest in fixed income securities such as government securities, money market instruments, corporate bonds and other debt securities. It would be wise to understand the following risk factors before investing in these funds.
  1. Interest rate risk – Bond prices and yields are inversely related. Net asset value (NAV) of debt funds replicates price of the underlying securities. Hence, when interest rates fall, NAV rises. When rates ease, long-term debt funds benefit more than short-term ones as they hold longer-tenor securities and vice versa.
  2. Credit risk – Credit rating issued by external rating agencies helps gauge credit worthiness of the bond issuer, i.e. the ability to make timely payments (principal and interest). A fall in credit rating drags down the price of the debt instrument and, thus, adversely impacts its NAV. Funds with higher exposure to AAA (top rated long-term debt) and A1+ (top rated short-term debt) securities have lower credit risk and higher credit quality. Typically, gilt funds have lower credit risk as they invest only in government securities vis-à-vis income funds which invest in government securities and corporate bonds. Investors need to check whether the fund has large exposure to low rated debt papers, which have the ability to generate high yields but are subjected to greater credit and liquidity risks.
  3. Liquidity risk – It refers to the salability of securities in the market. Funds with high exposure to low rated papers are exposed to liquidity risk as the fund manager may find it difficult to sell these papers.
  4. Reinvestment risk – This risk emanates when cash flows are reinvested at a rate that is less than the coupon rate of the bond. In a falling interest rate scenario, investors may face higher risk as proceeds will be reinvested at a lower rate, thereby reducing returns.
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Ways to measure risk

While risks associated with mutual funds cannot be overlooked, investors can measure them and choose the fund in line with their risk appetite. Some of the key ratios to measure risk are:

Standard deviation – One of the primary measures of risk, standard deviation helps identify consistency of a fund’s returns. It indicates the extent to which a fund’s returns fluctuate in relation to its average returns over a period of time. Lower the ratio, better for investors.

Beta – Investors can know a fund’s volatility compared to that of the benchmark through beta; in other words, sensitivity of fund’s returns to fluctuations in the market. A beta of 1 shows the fund’s NAV is closely aligned with that of the market. A beta of less than 1 implies the fund’s NAV will be less volatile than the benchmark index, and vice versa if the beta is more than one. Lower the ratio, better for investors.

Sharp ratio – This ratio measures how much excess return is made by the fund for the risk undertaken. It is the excess return over risk-free return divided by standard deviation. Higher the ratio, the fund has performed better in proportion to the risk taken by it.

R-squared – This ratio helps understand the correlation between the fund and the benchmark index, measured in the range of 0 to 100. R-squared of 100 means the fund moves in tandem with the benchmark index and R-squared of 0 means least correlation. Higher the ratio, better for investors.

Jensen’s alpha – This ratio measures the difference between a fund’s actual returns and its expected performance, given the level of risk. A positive alpha on the investment implies the fund has performed better than expected, given its beta. A negative alpha indicates it has underperformed. Higher the ratio, better for investors.

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Information ratio – It is a measure of a fund’s risk-adjusted returns. It is the excess return over the benchmark divided by the tracking error and is used to estimate fund managers’ skills. Higher the information ratio, better is the fund manager’s performance.

Portfolio turnover ratio – It shows the number of times portfolio securities are changed in a given year. In case of greater portfolio churning, the fund will incur higher transaction costs. However, a low ratio may not necessarily be a good indicator as a low ratio may indicate the fund manager is not churning the portfolio as per the changing market scenario.

Tracking error – One of the key ratios while investing in index funds, as it helps find the difference between fund’s returns and its benchmark’s returns. Funds with lower tracking error will provide returns in line with the benchmark.

In case of debt funds, investors can look at:

Average maturity – It is the weighted average of all the current maturities of debt securities held in the fund. It helps understand the average time to maturity of all debt securities held in a portfolio and is calculated in days, months or years.

Modified duration – It explains the sensitivity of the price of a bond to a change in interest rate. In other words, the extent of rise or fall in bond price, given a change in interest rate. It will help understand how the value of a portfolio would change in response to change in interest rates. Short-term debt funds will have moderate interest rate risk, while long-term gilt / long-term income funds will have highest interest rate sensitivity.

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3. Portfolio attributes

Portfolio is an integral part of a fund and has a huge bearing on its performance. Investors need to check the portfolio composition by looking at stock, sector holdings, maturity profile and credit quality, and see if it matches their risk appetite and returns expectation. Investors can use the aforementioned ratios for portfolio analysis.

4. Cost

An investor should understand the charges involved in mutual fund investment. Charges could be in the form of exit load levied if investors exit the fund in the specified time frame after investment. The purpose is to discourage early redemption and encourage investors to stay invested for the long term. In addition, mutual funds charge expense ratio which includes fund management fees, trustee fees, audit fees, registrar fees, and selling and distribution expenses. Though higher expense ratio drags down overall returns, it should not be the sole criteria for choosing a fund. Expense ratio for direct plans is lower than regular plans as former excludes distribution and trailing fees.

5. Fund house and management

It is imperative for investors to look at pedigree of the fund house. Investors should evaluate the fund manager’s profile, track record, investment style and market strategies they follow. Investors can use the additional information document available on the respective fund house website to understand the fund manager’s qualification and experience. In addition, investors need to look at the fund’s asset size, quality and independence of in-house research, operational efficiency, quality of services rendered by the fund house and adequacy and effectiveness of the risk management strategies.

Summing up

Details of the aforementioned parameters are available in the fund factsheet and other scheme-related documents such as Scheme Information Document or SID and Statement of Additional Information or SAI. To reiterate, do not pick up the recent winner but look for a consistent performer.

About sujoydhar

Sujoy Dhar is a business and technology and blogger. He is driven by the need to be creative and says that writing for various web properties allows him to stay up to date on one of the most rapidly evolving industries around. Each day provides Dhar with a new opportunity to educate readers about tech news and advances that help change the world for the better.

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