Rahul is a young mutual fund investor with a high-risk tolerance and a decent income. He has several goals. He comes across mutual funds that have delivered excellent 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 use 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 that 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.
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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 result from the 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:
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- Equity funds invest in equity and equity-related instruments and are exposed to the following risks:
- 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.
- Company-specific risk – Equity funds invest in companies across market capitalization (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 exposed to smaller companies that are not so well established are subjected to greater company-specific risk.
- 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 the case of international funds or country-specific funds.
- Liquidity risk – This risk emits from the lower trading volume of the stock, making an exit difficult. This is greater in the case of penny stocks (meager value).
- 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 unfavorable developments in an industry.
- Debt funds invest in fixed-income securities such as government, money market instruments, corporate bonds, and other debt securities. It would be wise to understand the following risk factors before investing in these funds.
- Interest rate risk – Bond prices and yields are inversely related. Net asset value (NAV) of debt funds replicates the cost 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.
- Credit risk – Credit rating issued by external rating agencies helps gauge the bond issuer’s creditworthiness, i.e., the ability to make timely payments (principal and interest). A fall in credit rating drags down the debt instrument’s price 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 and corporate bonds. Investors need to check whether the fund has a large exposure to low-rated debt papers, which can generate high yields but are subject to greater credit and liquidity risks.
- 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 them.
- Reinvestment risk – This risk emanates when cash flows are reinvested at 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.
Ways to measure risk
While risks associated with mutual funds cannot be overlooked, investors can measure them and choose the fund according to their risk appetite. Some of the key ratios to calculate risk are:
Standard deviation – One of the primary risk measures, standard deviation, helps identify a fund’s returns’ consistency. It indicates the extent to which a fund’s returns fluctuate about its average returns over some time—the lower the ratio, the better for investors.
Beta – Investors can know a fund’s volatility compared to that of the benchmark through beta; in other words, the sensitivity of the fund’s returns to fluctuations in the market. A beta of 1 shows the fund’s NAV is closely aligned with the market’s. 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—the lower the ratio, the 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 the standard deviation. The 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 from 0 to 100. An R-squared of 100 means the fund moves in tandem with the benchmark index, and an R-squared of 0 means the least correlation. The higher the ratio, the better for investors.
Jensen’s alpha – This ratio measures the difference between a fund’s actual returns and 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—the higher the ratio, the better for investors.
Information ratio – It is a measure of a fund’s risk-adjusted returns. The excess return over the benchmark is divided by the tracking error and is used to estimate fund managers’ skills. The higher the information ratio, the better the fund manager’s performance.
Portfolio turnover ratio – It shows how many times portfolio securities change 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. A low ratio may indicate the fund manager is not churning the portfolio per the changing market scenario.
Tracking error – One of the key ratios while investing in index funds is finding the difference between the fund’s and benchmark returns. Funds with lower tracking errors will provide returns in line with the model.
In the case of debt funds, investors can look at:
Average maturity – 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 in a portfolio and is calculated in days, months, or years.
Modified duration – It explains the sensitivity of a bond’s price to a change in interest rate. The extent of rise or fall in bond price is given a change in interest rate. It will help understand how a portfolio’s value would change in response to a interest rate changes. Short-term debt funds will have moderate interest rate risk, while long-term gilt/long-term income funds will have the highest interest rate sensitivity.
3. Portfolio attributes
The 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 ratios above for portfolio analysis.
4. Cost
An investor should understand the charges involved in mutual fund investment. Payments could be an exit load levied if investors exit the fund in the specified time frame after acquisition. The purpose is to discourage early redemption and encourage investors to stay invested for the long term. The mutual fund’s charge expense ratio includes fund management fees, trustee fees, audit fees, registrar fees, and selling and distribution expenses. Though a higher expense ratio drags down overall returns, it should not be the sole criterion for choosing a fund. The expense ratio for direct plans is lower than regular plans as the former excludes distribution and trailing fees.
5. Fund house and management
Investors must look at the 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 on the fund house website to understand the fund manager’s qualifications and experience. Also, investors need to look at the fund’s asset size, quality, 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 parameters above 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.
