Though mutual funds offer value-for-money to investors, there are a few risks associated with investing. Checking analyses and credit rankings with multiple sources is a requirement of intelligent investment
The growth of mutual funds as a worthy alternative to direct equity investment over the years has been humongous with the number of regulated open-end mutual funds worldwide increasing from 88,525 in 2011 to 114,131 last year, a growth of 29 per cent. Although growth of the mutual fund industry started in the US, where it still plays a vital role in stock markets, the trend has spread more recently to a significant number of countries around the world. In an age where information flow is smooth and quick, investors are increasingly concerned about fund selection, demanding detailed mutual fund information and investment advice. As a result of large number of funds in existence, evaluating and selecting funds can be particularly difficult and challenging.
So what are the metrics that are used to analyse and compare the performance of different mutual fundsij For debt schemes, credit rating is important as it is a well-known fact that debt funds are prone to risks like interest rate risk, credit risk and liquidity risk. While interest rate risk and liquidity risk affect returns and redemption of the debt investments, credit risk tends to affect the principal value of the investment. For that purpose, there are various credit rating agencies, like CRISIl, CARE, ICRA, which measure and evaluate the credibility and creditworthiness of the borrower. These ratings are derived on the basis of the credentials of the entity which may be the balance sheet, profit and loss statement, or any other financial information.
In case of debt mutual funds, the credit quality of the individual’s asset, management quality, diversification of the portfolio and operational policies are checked for the purpose of final rating. In the long-term, funds with AAAmfs carry the highest credibility and are ranked among the top funds, while in the case of short-term debt schemes, A1mfs are at the highest score. Another performance indicator an investor should be aware of while investing in a debt funds is average maturity, as debt funds invest in various fixed income bearing securities wherein each security in the portfolio may have different maturity.
Average maturity refers to the weighted average of all current maturities of debt securities held in the portfolio and gives the mean age of every debt security in the fund portfolio. The higher the average maturity of a debt fund, the longer it will take for each security to mature in the portfolio and vice-versa. Since bond prices are inversely related to interest rate movement, a debt fund, which has several long-maturity bonds in its portfolio, will have higher interest rate sensitivity and will be vulnerable to greater Net Asset Value (NAV) fluctuations. Investors should avoid investing in debt funds having bonds with higher maturity.
Equity mutual fund investors can also use several ratios to analyse the performance of their investments. It is a misconception that higher returns mean better performance since returns cannot be judged in isolation and have to be simultaneously measured with the risk taken to generate returns. This is where Sharpe ratio is helpful as it assesses the returns generated by a portfolio against per unit of risk undertaken. A higher Sharpe Ratio represents a higher return generated per unit of risk.
Investors should also note that any ratio would only make sense if it is compared to the benchmark index. Treynor ratio, also known as reward-to-volatility ratio, like Sharpe ratio, helps analyse returns in relation to the market risk of the fund, except that it uses beta or market risk as volatility measurement and gives return over the risk-free per unit of market risk, whereas Sharpe Ratio uses standard deviation.
By comparing beta of the investment to the volatility in the entire stock market, investors can assess the risk associated with investment. Stocks with a beta greater than one tend to increase and decrease value faster than stocks with a beta of less than one. Higher the Treynor Ratio, the better the performance under analysis. For instance, if the fund’s average return is 10 per cent and the risk free rate is seven per cent, the difference becomes three per cent. If the historic beta of the fund is 1.5, the Treynor Ratio is two (three divided by 1.5). This means that in past, the fund has given two units of return for one unit of its market risk.
Investors and analysts use this calculation to compare different investment opportunities’ performance by eliminating risk due to volatility component of each investment. By cancelling the affects of this risk, investors can actually compare the financial performance of each fund or investment. For example, one fund manager might make better investment decisions for long-term profitability but another fund outperforms it in the short-run because of market swings.
The Treynor calculation cancels out this market instability to show which fund manager is actually making better decisions and creating a fundamentally more profitable investment. Jensen’s alpha, another performance indicator, is one of the ways to determine if a portfolio is earning the proper return for its level of risk. If the value is positive, the portfolio is earning excess returns and the fund manager has been able to stay ahead of the stock market with his stock picking skills.
Another variation of Sharpe ratio is Sortino ratio that uses only downward deviation instead of both upward and downward deviation in Sharpe ratio and since investors are only concerned about the downward volatility, Sortino ratio presents a more realistic picture of the downside risk ingrained in the fund or the stock which does not penalise a portfolio manager for volatility, and instead focuses on whether returns are negative or below a certain threshold.
Although Sharpe ratios are better at analysing portfolios that have low volatility, Sortino ratio is better when analysing highly volatile portfolios and a large Sortino ratio indicates there is a low probability of a large loss. Another interesting performance evaluation metric is Omega ratio, which again like Sharpe ratio, is a risk-return measure and helps to assess the attractiveness of a mutual fund. It is a relative measure of the likelihood of achieving a given return, such as a minimum acceptable return (MAR) or a target return. The higher the omega value, the greater the probability that a given return will be met or exceeded.
Although investors invest in mutual funds to take advantage of a professional fund manager to achieve diversification and reduce market risk, this purpose is lost, mostly, as there is a tendency by fund managers to invest large proportion of the portfolio in few stocks and sectors to take advantage of any upswings in the market. This leads to a portfolio concentration risk and caution needs to practiced by investors to examine the stocks or sectors, where the fund is skewed by taking the sum of investments in the top five stocks or sectors of the fund and choose smartly after analysing it this investment pattern matches their investment goals and objectives.
In addition to portfolio concentration, investors should also use portfolio turnover percentage to evaluate the performance of mutual funds, which represents the number of times a fund manager changes the stocks during the course of a year. The portfolio turnover is determined by taking the fund’s acquisitions or dispositions, whichever number is greater, and dividing it by the average monthly assets of the fund for the year.
For example, a fund with a 25 per cent turnover rate holds stocks for four years on an average. Higher turnover rates mean increased fund expenses, including negative tax consequences, which can reduce the fund’s overall performance.
Apart from ratios that evaluate the portfolio of any mutual fund, investors should also evaluate the operations of a mutual fund. One of the main ratios is expense ratio, which is the percentage of assets paid to administer, manage (including the auditor and advisor fees) and advertise or to meet other similar expenses of the mutual fund. If the funds’ assets are small, the expense ratio could eat into the smaller asset base. Generally, a lower ratio means more profitability and a higher ratio means less profitability.
As one can see, there are more than one ways to evaluate the performance of mutual funds. However, astute investors should understand that there is no single ratio or measure that is reliable all the time, nor any single rating company whose advice and analysis is always correct. Checking analysis and rankings with multiple sources is a requirement of intelligent investing and a process which should never be omitted in determining which mutual fund to invest in.
(The writer is Assistant Professor, Amity University)
