How to evaluate Mutual Funds?

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For most investors, the process of evaluating and selecting a mutual fund is rather straightforward. It begins with a visit to any website that has data related to mutual fund returns. Funds are sorted based on their returns to identify the best performers. A discerning investor is likely to go a step further and assess the risk-adjusted performance too. Funds that make the grade on both the return and risk-adjusted return fronts are earmarked for investing.

The trouble with this approach is that it focuses solely on the past. In other words, the investor assumes that the future will mirror the past. But that may or may not be true. For instance, if the factors that drove the impressive showing have changed, then the past performance might be of little relevance.

Hence, there is a need to go beyond performance and instead focus on forwardlooking aspects, i.e. factors that can be predictive of performance.

We list five such factors that investors should focus on while evaluating a fund:
People: Find out more about the individuals responsible for running the fund, i.e. the portfolio manager and the investment team supporting him. Focus on the manager’s experience and his/her areas of expertise. Ideally, one should seek managers who are experienced and have successfully navigated a market cycle. Assessing the analyst and research resources available to the manager is important too.

Process: This entails evaluating the investment strategy being plied on the fund. Broadly speaking, a process which is simple, well-defined and repeatable is preferable. Furthermore, the manager’s ability to execute it is no less important. Simply put, investors must find out if the strategy is robust and can be consistently executed with skill by the manager.

Parent: This is an assessment of the asset management company (AMC). The policies put in place by the AMC have a bearing on fund performance. For instance, an AMC that fails to retain talent could struggle on the fund performance front as well. If the investment team is incentivized for short-term performances, that will influence their investment style. An AMC which recklessly launches trendy funds is typically likely to be more interested in its bottom-line rather than investors’ longterm interests.

Performance: Evaluate if the fund’s perfor mance matches what one expects given the process being plied. For instance, a valuation-conscious process is unlikely to deliver at a time when markets are rewarding expensive stocks. Also, while returns are important, greater emphasis must be laid on the risk-adjusted showing over time.

Price: Expenses charged to the fund can and do have a bearing on its long-term performance. In debt fund categories where margins can be wafer thin, the importance of keeping expenses low is further accentuated. Find out how the fund compares to its category peers on the expense ratio front. All other factors being equal, an inexpensive fund should be preferred over an expensive fund.

The aforesaid factors should be considered in combination (and not individually) while forming an opinion on the fund. Lastly, investors must remember that they are investing their monies for the future and hence the need to focus on more than just the past performance.

Here are five risk-return ratios that investors can learn

Standard deviation (SD):

 

This is a statistical measure of risk which indicates how much the return of a fund has deviated from its average return. When a fund has a high SD, the range of returns is wider, implying greater volatility. This makes the fund more risky than one with a lower SD.

 

Sharpe ratio:

 

A measure of risk-adjusted return, it is indicative of how a fund has performed relative to the risk it took on. Since it measures risk-adjusted return, a higher Sharpe ratio is a positive.

 

Sortino ratio:

 

Another measure of risk-adjusted return, but unlike Sharpe ratio it considers downside risk or ‘bad’ volatility. A higher Sortino ratio indicates that the fund has suffered lower downside volatility versus a fund with lower score.

 

Up-capture/down-capture ratio:

 

The upside-capture ratio measures how a fund performs in a rising market relative to a relevant index. The ratio demonstrates how much of the benchmark index’s or peer group’s up movement the fund has been able to capture. Similarly, the downside-capture ratio is a measure of what percentage of the index’s or peer group’s fall was captured by the fund.

 

Information ratio:

 

This measures excess returns clocked by a fund versus relevant benchmark index, and the consistency with which they were clocked. So, higher the information ratio, the better it is.

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