Mutual Performance Criteria
Mutual Funds, Personal Finance, Wealth Management

How to Evaluate Mutual Fund Performance? Criteria You Need to Know

Though the Mutual Fund Sahi Hai campaign by AMFI  needs to be more convincing, yet the message of the campaign is Sahi. It all started in India with the first scheme Unit 64. After years there as another scheme Master Share which received tremendous response from the investors. The investors invested in the new scheme on a massive scale and expected return like from an IPO.

They realise the difference between an IPO or Shares and Mutual Funds soon thereafter. They were dejected. Therefore, in 90s mutual funds schemes got momentum with the private players coming in.

It was very late investors realised mutual fund is for the long term and reasonable return. It cannot give a huge return like some of the equity shares used to give. (Mostly it was at the time of Harshad Mehta scam in 1992 or Ketan Parekh scam in 2000, equity shares offered exorbitant gains).

The market stabilised after 2000, many schemes and many players of the mutual fund created the desired depth and alert SEBI everything was responsible for a mammoth growth of the Mutual Fund Market in India. As of April 2019, Indian Mutual Fund industry is Rs.25 Lakh Crore. (Rs. 24.79 trillion)

The number of folios is 82.7 mn. which is quite a few in a country of 1300 mn.

MF schemes are catering to short term (few days) to long term investors. It also caters to the various risk profile of investors. Bond/ Debt fund to Equity fund and everything in between. The minimum size of an investment is also very investor friendly. Investors can start with as low as Rs.100/-.

Usually, investors invest in a mutual fund based on the advice of investment advisors. Those who are little aware check the past performance of the fund/scheme and take a decision.

It is believed that the performance of equity schemes are depended on the equity market. Yet different schemes under the same category offer different returns. This is where the role of fund managers comes in.

There are some criteria to evaluate the performance of the scheme and performance of the fund manager.  Investors can differentiate what percentage of the return is due to the market performance and what percentage is due to the performance of the fund manager.

Handpicked related post: You Need to Know 4 Aspects of Personal Financial Planning

In this post, we will see the criteria to evaluate the performance of the Mutual Fund schemes. this will help them select the right mutual fund scheme.

Sharpe Ratio

The ratio explains whether the fund returns are due to intelligent investment decisions or the result of excessive risk taken by the fund manager.

How to analyse it: It is measured by subtracting the risk-free return from the fund’s return and dividing the result by the standard deviation of its return.

The risk-free return in India is considered either to be the bond rate or 181-day treasury bill rate. The higher the ratio, the better is the fund’s risk-adjusted performance.

Important Note: A fund may fetch higher returns than its peers, but it’s usually a good option only if it doesn’t take too much risk in doing so. This ratio helps us differentiate between the two.

The higher the ratio better it is the fund manager’s performance. A ratio of 1 + is good, 2 +  is very good, and 3+ is excellent.

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Alpha

It quantifies what the fund manager brings or takes away from the return of an investment, which is based on his skill and value addition that he provides. This means whether the fund manager has performed better than the benchmark index?

How to analyse it: It is a measure of performance on a risk-adjusted basis. Alpha considers the price volatility of the fund and compares its risk-adjusted performance with that of the benchmark index

The excess return of the fund relative to the benchmark index is called alpha. A positive alpha of 1 means that the fund has outperformed its benchmark index by 1%, and a similar negative alpha indicates an underperformance of 1%.

Important Note: Funds with negative alpha means the fund manager is not generating any value-added return in excess of the market. The more positive an alpha, the better it is.

Beta

It’s also a measure of volatility and tells how risky a fund is in comparison to the market.

How to analyse it: It measures the sensitivity of a fund’s return to swings in the market. The market’s beta is always 1. The index funds’ beta value is equal to that of the market. If the beta is less than 1, it indicates less volatility than the market, and vice-versa.

Important Note: Conservative investors whose focus is capital preservation should look at funds with low betas as their values are less likely to decline than those of the benchmark index in a bear phase.

Standard Deviation

This is a statistical definition.

How to analyse it: It measures the degree to which a fund’s return fluctuates in relation to its average return over a period of time. The higher the standard deviation, the more volatile the fund, and hence, riskier as the fund’s performance will rise and fall drastically in a short period of time.

Year Portfolio A Portfolio B Portfolio C
Year 1 10.00% 9.00% 2.00%
Year 2 10.00% 15.00% -2.00%
Year 3 10.00% 23.00% 18.00%
Year 4 10.00% 10.00% 12.00%
Year 5 10.00% 11.00% 15.00%
Year 6 10.00% 8.00% 2.00%
Year 7 10.00% 7.00% 7.00%
Year 8 10.00% 6.00% 21.00%
Year 9 10.00% 6.00% 8.00%
Year 10 10.00% 5.00% 17.00%
Average Returns 10.00% 10.00% 10.00%
Annualized Returns 10.00% 9.88% 9.75%
Standard Deviation 0.00% 5.44% 7.80%

Important Note: Usually, as standard deviation increases, so does the return due to the risk-return trade-off. But if two funds with the same investment objectives deliver similar returns, the one with the lower deviation is a better choice as it maximises the returns for the given risk level.

In the above example, the performance of Portfolio A is better than the performance of Portfolio B and the performance of Portfolio B is better than the performance of Portfolio C. Though the average return for all three are same 10%.

These are some of the criteria which measure fund managers’ performance along with the Funds’ performance. Remember equal returns on two schemes in the similar category of funds do not make them equally performing. Investors need to apply the ratios explained above to know the difference.

Mutual Fund Sahi Hai but performance analysis also should be Sahi to make the right investment decision.

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“Mutual funds were created to make investing easy, so consumers wouldn’t have to be burdened with picking individual stocks.” Scott Cook

Yes, Mutual Funds were created for investors who do not want to or do not know how to analyse the companies for direct equity investments.

Caution: Mutual Fund is for the average return with reasonable safety, it cannot give exponential return some of the stocks had given and could give.

Next time we will explore direct equity shares investment criteria. Subscribe to get regular new post from this Blog.

You may also like to read: 2 Powerful Wealth Creation Books To Read ASAP

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