Several factors one should consider before making a decision on choosing a mutual fund (MF) product. Investors should not totally decide on past performance of the MF scheme, but exploring several other factors as well.
The past performance of a fund is important in analysing a MF scheme. But remember that past performance is not everything, as it may or may not sustain in future. Therefore, your investment decision should not hinge on this factor alone. A thorough evaluation is necessary. Past performance just throws some light on the track record of the fund. And, if the fund has a well-established track record, the likelihood of it performing well in the future is higher than a fund which has not performed well. However, prudent and holistic assessment is essential. Under the performance criteria, you should do the important analysis.
Compare funds: A fund’s performance in isolation does not indicate anything. Hence, it becomes crucial to compare the fund with its benchmark index and its peers. Again, be careful, while selecting the peers for comparison. For instance, it doesn’t make sense comparing the performance of a mid-cap fund to that of a large-cap.
Remember: Don’t compare apples to oranges
Performance across time periods: It is important to evaluate how a fund has performed over different market cycles (especially during the downturn).
Remember: Choose a fund like you choose a spouse – one that will stand by you in sickness and in health.
Judge the returns: Returns are obviously important but not the only parameter that one must look at while evaluating a fund. Many investors simply invest in a fund because it has given higher returns in the past. In our opinion, such an approach for making investments is incomplete. In addition to the returns, you as an investor must also look at the risk parameters. They explain how much risk the fund has taken to clock higher returns.
To put it simply, risk is a result or outcome, which is other than what is/was expected. The outcome, when different from the expected outcome is referred to as a deviation. Risk in mutual funds is normally measured by Standard Deviation (SD or STDEV). SD signifies the degree of risk the fund has exposed its investors to.
From your perspective, as an investor, evaluating a fund on risk parameters is important; because it will help you check whether the fund’s risk profile is in line with your risk profile or not. If two funds have delivered similar returns, then as a prudent investor you should invest in the fund which has taken less risk i.e. the fund that has a lower SD.
Judge the risk-adjusted returns: This is normally measured by Sharpe Ratio (SR). It signifies how much return a fund has delivered vis-à-vis the risk taken. Higher the Sharpe Ratio, better is the fund’s performance.
For you, from an investor’s perspective, Sharpe Ratio is important because you should choose a fund, which has delivered higher risk-adjusted returns in the past. After all, there needs to be an effective risk-return trade off. In fact, this ratio will tell you whether the high returns of a fund are attributed to good investment decisions, or to higher risk.
The portfolio characteristics and investment strategy are important criteria for a mutual fund. The quality of portfolio is what reflects in the funds overall performance. Funds that follow long-term investment strategy and have managed their portfolio astutely have been successful in the past.
Under the portfolio quality criteria, you should do the following…
Assess the portfolio concentration: Funds that have a high concentration in particular stocks or sectors tend to be very risky and volatile.
Hence, if you have a very high-risk appetite, only then you must invest in these funds.
Ideally, a well-diversified fund should hold no more than 50-55 per cent of its assets in its top-10 stock holdings.
Remember: Make sure your fund does not put all its eggs in one basket.
Check the Average Maturity, Modified Duration & YTM:
These parameters are important while evaluating debt mutual funds.
The Average Maturity: It refers to weighted average time until all securities in a debt portfolio of a mutual fund mature. Lower the average maturity; the better it is in terms of the interest rate risk and lower volatility.
Modified Duration (MD), reflects the responsiveness of the debt securities' price with the change in interest rate. It is based on the inverse relationship between the price of the bond and interest rates.
The MD is used to measure the volatility of debt fund. Higher the MD, higher the interest rate sensitivity. YTM (or Yield to Maturity) refers to the rate of return anticipated on a debt portfolio, if the securities in it are held till maturity. It is also commonly referred to as the yield on the debt portfolio.
Credit Risk Of Portfolio Constituents
Along with interest rate risk, debt funds also carry credit risk. Debt securities are rated by the credit rating agencies on the issuer’s creditworthiness and capacity to pay back. Fixed income securities that are rated AAA is considered to be ‘highest’ that carry low credit risk. Securities that receive low credit rating like ‘C’ carry high default risk. Hence, it’s crucial to check the credit ratings of each portfolio constituents of debt fund. A portfolio that constitutes fixed income securities that are highly rated are ideal to invest in.
The author is head and founder of Mumbai-based financial advisory firm Money Mantra. He can be reached at email@example.com