How to evaluate & compare Mutual Funds performance

Compare Mutual Funds- Learn how to evaluate Mutual Funds performance

Compare Mutual Funds- Learn how to evaluate Mutual Fund performance

It has been almost 25 years since private players have participated in the Mutual Fund industry. Still, there are lots of milestones to be reached and many records are yet to be broken. My utmost endeavor has been to make general investors aware of this industry and its capability in making a handful wealth for the investors. Having regard to that, today I have decided to write a blog post on Compare Mutual Funds- Learn how to evaluate Mutual Fund performance.

There are some criteria based on which the performance of mutual funds are analysed. These parameters help an investor to review his portfolio and analyse its performance based on certain key points.

Evaluate and compare Mutual Funds performance

Every mutual fund AMC publishes fact sheets on a monthly basis. These are primarily used as a source of information to review, analyse and compare mutual funds performance. Therefore, this helps prospective investors to take an informed decision before investing in any particular products of fund House and to evaluate its performance.

So, before evaluating and compare Mutual Funds performance, the first one needs to have some ideas on the following key factors.

  • Relative Return;
  • Relative Volatility;
  • Risk-Adjusted Return;
  • Sharpe Ratio;
  • Treynor Ratio;

⇒What factors should you evaluate and analyse to compare Mutual Funds performance?

Evaluating risk and return is considered as the first step towards mutual fund performance analysis. This information obviously is given in the fact sheets but one needs to understand and look at things beyond fact sheets. One must consider the following key factors while making any analysis of the fund’s performance.

  • Return generated by the fund in the past.
  • Has the fund been able to generate better returns than the market benchmark return?
  • Has the fund ranked among the top 25% of funds in its category in terms of returns?
  • The risk profile of the fund itself.
  • Did the fund assume risks that the investor might not have expected?
  • The risk profile of the fund than its benchmark.

Compare Mutual Funds

⇒Crucial factors to compare Mutual Funds performance

Compare Mutual Funds performance

Relative Return

A mutual fund’s return will be in line with the performance of the asset class in which it invests. Generally, fund managers adopt investment strategies and styles to generate better returns than the market benchmark.

Generally, market indices such as BSE 200, NIFTY 50 are used as benchmark indices.

The benchmark selected by the fund must reflect the fund’s investment objective. The returns generated by a fund in different calendar years and different holding periods will be shown relative to the benchmark’s returns in the same period. This enables the investors to analyse the performance in different market situations and the ability to outperform the benchmark consistently. Also, cumulative return numbers such as return since inception show the performance of the fund for longer holding periods.

Relative Volatility

A fund primarily invests in a combination of different assets classes. Therefore, a fund only holding equity investments would definitely bear greater volatility and also higher returns over the long term as compared to a fund that has a combination of both debt and equity. Higher the volatility in returns, higher the risk in the fund.

Further, within the asset class, the selection of subcategories also have an impact on the nature and type of return. For example, a fund holding only short-term debt instruments will have lower returns as compared to a fund holding long-term debt instruments. Also, its return will be less volatile. Similarly, a large-cap fund will experience lesser volatility as compared to a mid cap or small cap fund.

NAV  movements over a period of time are represented in a graphical format by common sizing the NAVs and benchmark values to the same number. Actually, this common size graph depicts the actual behaviour of NAVs over a period of time and helps in the visual assessment of risks. One graphical NAV movement simple graph is shown below for better understanding of the same.

[visualizer id=”1162″]

Risk-Adjusted Return

Risk and return have a direct relationship between them and they move together. A fund may have fetched a higher return but at the cost of a higher level of risk. The risk-adjusted return is considered as a tool to analyse whether the fund has justified by taking a higher risk in order to deliver a higher return. Funds disclose risk-adjusted return in the form of Sharpe ratio and Treynor ratio in their fact sheets. Thus, I can say that these two ratios depict the risk-adjusted return delivered by the fund itself for investment decision making.

Sharpe Ratio

The Sharpe ratio compares the excess return delivered by the fund over and above the risk-free return rate with its risk measured by Standard Deviation. Higher the ratio, the better it is when similar funds are compared for the same period. This ratio is used to rank funds within the same category. Therefore, this ratio plays a significant role in order to compare mutual funds. This helps an investor to evaluate, analyse the performance of a particular fund as compared to other similar types of fund and helps them to take an informed decision regarding investment in the fund. The formula of Sharpe ratio is given below.

Sharpe ratio= (Return of the fund-Risk fee rate)/Standard Deviation of the fund

Treynor Ratio

The Treynor ratio compares the excess return delivered by the fund over and above the risk-free return with its risk measured as Beta of the Portfolio. The formula of Treynor ratio is given below.

Treynor Ratio= (Return of the fund-Risk fee rate)/Portfolio Beta

Now, let’s take an example to understand how to calculate the above two ratios.

Example: A small-cap fund X has earned a return of 25% and its Standard Deviation is 14%. During the same period, another small-cap fund Y has earned a return of 32% with a Standard Deviation of 18%. The Beta of fund X is 1.2 and beta of fund Y  is 1.3. The risk-free return is 6%. Now compute using the above two ratios which fund has delivered a better risk-adjusted return?

 First, we need to calculate the excess return for two funds.

Excess Return:

Fund X=  25%-6%  = 19%

Fund Y=  32%-6%   =26%

Sharpe Ratio:

Fund X = 19/14 = 1.36

Fund Y = 26/18  =1.44

Treynor Ratio:

Fund X = 19/1.2 =15.83

Fund Y = 26/1.3  =20.0

Final word on Compare Mutual Funds- Learn how to evaluate Mutual Fund performance

Therefore, from the above example, it is evident that fund Y has performed better in both the segment or ratios by delivering a better risk-adjusted return. Both the ratios are better for fund Y. This shows that it is better to invest in fund Y since it has delivered a higher return for per unit of risk assumed. Investors should give risk-adjusted returns only while comparing the performance of two funds for taking any financial decision and not the nominal returns only.

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