Chapter 8: How to Evaluate a Mutual Fund
In the dynamic landscape of investments, mutual Funds stand out as a popular choice for both seasoned investors and newcomers seeking diversified portfolios.
But as we all know, like all investments, Mutual funds are subject to market risk. A mutual fund’s performance is based on the interplay of various factors that determine whether it will outperform the markets or underperform.
The performance of a Mutual Fund is not merely a result of chance or luck. Still, it is shaped by many variables, ranging from economic indicators to the strategies deployed by fund managers. From market trends and macroeconomic conditions to the fund’s asset allocation and management style of investing, each component plays a pivotal role in determining the fund’s trajectory.
By unraveling these factors, investors can gain valuable insights into how Mutual Funds operate within the broader financial ecosystem and make educated choices tailored to their investment objectives.
In this chapter, we’ll explore the complexities influencing Mutual Funds’ performance, shedding light on the different aspects of the fund’s performance matrix.
Factors that affect the performance of a mutual fund
Here are some key elements that influence how well or poorly a mutual fund performs:
Management of the Mutual Fund
The skill, experience, and investment philosophy of the fund manager(s) play a crucial role in a mutual fund’s performance. A skilled manager with a well-defined investment strategy can generate better returns by making informed decisions about which securities to buy or sell and when to make those transactions.
Consider a mutual fund manager as a Formula 1 driver. A well-trained F1 driver who manages to navigate the race track cautiously under all weather conditions will emerge as a winner at the finish line. Similarly, a fund manager capable of managing a fund under all market conditions has a better chance of outperforming the markets. A better chance, for lack of a better word, since no one can predict the market movements accurately and consistently every single time.
Therefore, it is important to know about the fund manager’s past track record in fund management before selecting a mutual fund, as the fund only performs if the fund manager performs well.
Prevailing Market Conditions
The overall state of the markets, including factors like economic growth, interest rates, inflation, and geopolitical events, can significantly impact a mutual fund’s performance. Funds invested in stocks tend to perform better during periods of economic expansion and market rallies, while debt funds may benefit from falling interest rates. It is, therefore, important to know market cycles and keep track of the overall economic conditions while choosing a fund based on the investment objectives.
A good mutual fund managed by an extremely talented and competent fund manager may still not perform if the market conditions are unfavorable. Similarly, a decent fund with a capable fund manager and a good track record may outperform the markets if the conditions are favorable.
Asset Allocation of the Portfolio
The asset allocation strategy of a mutual fund, which refers to the proportion of investments in different asset classes (e.g., stocks, bonds, cash), can affect its performance. Asset Allocation decides a mutual fund’s volatility and the potential return outcome for its investors.
Funds with a more aggressive asset allocation towards equities may experience higher volatility but potentially higher returns over the long run. In contrast, conservative funds with a higher allocation to fixed-income securities may be less volatile but generate lower returns.
How crucial is asset allocation for a mutual fund manager managing a mutual fund?
Since asset allocation determines the fund’s risk-return profile and its sensitivity to market fluctuations, different asset allocations can lead to varying performance levels under different market conditions. Choosing the right asset allocation saves the fund from higher volatility and gives these fund managers an edge against its peers (competing mutual funds).
Comprehending asset allocation is also crucial for investors seeking to gauge and optimize a mutual fund’s performance.
Sector/Industry Exposure
For certain sector-specific or industry-focused mutual funds, aka thematic funds, the performance of the underlying sector or the industry can significantly influence the fund’s returns. For example, an IT fund’s performance will largely depend on how well the technology sector performs during a given period.
Sector-specific funds are usually high-risk funds. Depending on the industry’s performance, they either outperform their investors or underperform for the longest period of time. That’s because markets move in cycles, and not all sectors may outperform at the same time.
Also, higher dependency on a sector attracts higher volatility since the fund is prone to Unsystematic risk, which is the risk of having higher volatility due to any negative news for the industry.
Expense Ratios, Excessive Churning & Impact Costs
As we have discussed, the expense ratio represents the annual fees charged by the fund for management and administrative expenses. These charges can impact the fund’s returns.
All else being equal, funds with higher expense ratios may underperform compared to those with lower expense ratios. Although expense ratios don’t have a major impact on a mutual fund’s performance in the short term, in the longer term, they can significantly compound, leading to vast differences in the performance matrix for investors.
Other expenses, like higher brokerages due to high portfolio churning, meaning a fund manager who keeps buying and selling stocks in the portfolio on a frequent basis, could lead to transaction costs. This can also impact the fund’s performance, as ultimately, the costs are deducted from the NAV, thus lowering the overall performance.
Higher impact costs are another variable that can impact a fund’s overall performance. A fund that invests in illiquid stocks or stocks with low volumes could face higher impact costs while investing in them. Low volumes could increase the “spread,” meaning the difference between the buying and selling prices, and the variance could be even more if the number of buyers and sellers is less in that stock. This ultimately impacts the purchasing or selling price, ultimately affecting the overall performance of a fund.
Tracking Error (for Index Funds)
For index funds, which aim to replicate the performance of a specific market index, the tracking error – the difference between the fund’s returns and the index’s returns – can impact performance. Funds with lower tracking errors are more efficient in replicating the index’s performance.
Tracking error is usually caused by factors such as a fund manager’s inability to buy the assets/stocks of the underlying index, sudden movements that increase the volatility in the stocks, or low liquidity in the stocks of the underlying index.
The best index funds have the least tracking error, showcasing the efficiency of the fund manager.
Fund Size and Cash Flows
The size of a mutual fund and the inflows and outflows of investor money can affect its performance too. Larger funds may find it harder to maintain their agility in buying and selling securities, while significant redemptions can force fund managers to sell holdings, potentially impacting performance.
So these are some of the factors that can affect the overall performance of mutual funds.
By understanding these factors, investors can make more informed decisions when selecting and evaluating mutual funds for their investment portfolios. Regular monitoring and analysis of a fund’s performance, considering these elements, can help investors ensure that their investment goals are being met.
Several statistical tools and metrics can help track and evaluate a mutual fund’s performance. Here are some commonly used tools…
Mutual Fund Evaluation Metrics
- Returns
- Risk
- Risk-Adjusted Returns
- Peer Group Comparison
- Portfolio analysis.
1. Returns
The simplest and greatest way to evaluate the performance of a mutual fund before investing is to evaluate and compare the returns. You can use the following to evaluate a mutual fund scheme with its peers:
- Annualized Returns: This measures the fund’s average annual return over a specified period, allowing you to compare its performance against benchmarks or other funds.
- Compounded Annual Growth Rate (CAGR): This metric shows the annual growth rate of an investment over a specific period, considering the compounding effect of reinvested dividends or capital gains.
Indeed, the greater returns a fund generates, the better it is for investors, but following only returns in isolation could be a mistake, simply because past performance may not guarantee future returns.
Therefore, we need to evaluate returns based on the risk that a fund is taking to generate returns for its investors.
2. Risk Metrics
These statistical tools will help us gauge how much risk a mutual fund manager is undertaking to deliver the overall performance or returns.
- Standard Deviation measures the volatility or risk associated with a fund’s returns. A higher standard deviation indicates higher fluctuations in returns and thus, higher risk.
- Beta: Beta measures the fund’s volatility about the overall market. A beta of 1 indicates that the fund moves in sync with the market, while a beta of less than 1 suggests lower volatility, and a beta greater than 1 implies higher volatility.
3. Risk-Adjusted Performance Metrics
As we discussed earlier, choosing a mutual fund solely based on past performance could be misleading since past performance does not guarantee future returns.
So, how do we evaluate which fund to choose? The answer lies in comparing the funds based on their risk-adjusted returns.
Risk-adjusted Returns simply means that in a given period , when you compare the performance of 2 funds, we need to understand which fund has taken the least risk to generate the same or more returns.
The fund that generates the same or more returns but takes lesser risks shows the efficiency of the fund management and the capability of the fund manager who is generating the returns for its investors. Therefore, a risk-adjusted performance metric can help investors make an optimal decision while choosing a fund to invest their savings.
Here are some of the risk-adjusted performance metrics that you can use –
- Sharpe Ratio: This ratio measures the fund’s risk-adjusted returns by dividing the excess returns (over the risk-free rate) by the standard deviation. A higher Sharpe ratio indicates better risk-adjusted performance.
- Treynor Ratio: This ratio is similar to the Sharpe ratio, but it uses beta instead of standard deviation as the risk measure, making it more suitable for diversified portfolios.
- Alpha: Alpha measures the fund’s performance relative to its expected return based on its level of risk. A positive alpha indicates that the fund has outperformed its benchmark, while a negative alpha suggests underperformance.
By using risk-adjusted performance metrics, you can gauge investment quality simply because they can allow you to filter riskier investments from less risky ones and help you invest without any uncertainty.
4. Peer Group Comparison
Peer group comparison is one way to evaluate a fund’s performance. It’s also a relative analysis tool that helps you gauge a fund’s performance.
- Category Returns: Comparing a fund’s returns to the average returns of its peer group (e.g., large-cap equity funds, mid-cap funds, etc.) can provide insights into its relative performance.
- Category Rank: This ranks a fund within its peer group based on various performance metrics, allowing you to assess how it fares against similar funds.
You may also use the risk metrics in the peer comparison method to refine your research.
5. Portfolio Analysis
This metric allows you to gain insights into the intricacies. It gives you insights into how the mutual fund portfolio is structured in terms of the asset mix and also allows you to determine the efficiency of the fund management.
Portfolio Turnover Ratio: This measures the frequency of a fund’s buying and selling of securities within a given period, providing insights into the fund manager’s investment strategy and potential impact on transaction costs.
Concentration Ratios: These ratios, such as the concentration of the top 10 holdings, measure the degree of diversification within the fund’s portfolio.
By analyzing these metrics, investors can understand a mutual fund’s performance, risk profile, and how it compares to its peers and benchmarks. These statistical tools can be found on Dhan’s mutual fund platform and in the fund fact sheets or reports provided by fund houses.
This concludes this chapter. In the next chapter, we will discuss how you can choose the best mutual fund for yourself!