Through mutual funds, small investors can put money in the stock markets and benefit from any upswing in share prices

The growth of mutual funds (MF) as a worthy alternative to direct equity investment over the years has been humongous. According to the Association of Mutual Funds in India (AMFI), the Assets Under Management (AUM) of the Indian MF industry has grown from Rs 6.28 trillion in September 2009 to Rs 24.51 trillion in September 2019, a four-fold increase in a decade. Depending on how the money is being invested, there are different categories of MFs based on asset class, structure and investment objective. On the basis of asset class, MFs are of the following type:

Equity funds: Here at least 70 per cent of the money is invested in stocks of listed firms. Equity funds can be further classified based on sectors like infrastructure funds, IT funds; size of the company like large cap, mid-cap; purpose, like equity-linked savings schemes that give benefit of tax savings; tracking a index through index funds; or fund of funds (FoF) which invests in other MFs.

Debt Funds: Here, majority investments are in debt instruments like Government bonds, firm debentures and other fixed income assets.

Hybrid/Balanced Funds: These invest in both the asset classes of equity and debt instruments with the proportion of equity and debt varying in different funds. A balanced fund could be 60 per cent invested in equities with remaining 40 per cent  in debt or vice-versa.

Money Market Funds: These invest in money markets that are short-term in nature and are highly liquid and are mostly preferred by companies to park their idle cash and by large institutions and the Government to meet their short-term fund requirements.

MFs can also be categorised based on structure as open-ended or closed-ended. Although the industry is growing, investors are also increasingly concerned about fund selection and are demanding detailed information and investment advice. Due to the large number of funds, evaluating and selecting MFs can be challenging.

So what are the metrics that are used to analyse and compare the performance of different MFs? For debt schemes, credit rating is important as it is a known fact that debt funds are prone to interest rate risk, credit risk and liquidity exposure. While interest rate perils and liquidity exposure affect the returns and redemption of debt investments, the credit risk tends to affect the principal value of the investment. Hence, various credit rating agencies, like CRISIL, CARE, ICRA, measure and evaluate the credibility and creditworthiness of the borrower and 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. Equity MF 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 the 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 the volatility measurement and gives the return over the risk-free per unit of market risk, whereas Sharpe Ratio uses standard deviation.

By comparing the beta of the investment to the volatility in the entire stock market, people can assess the risk associated with the investment. Stocks with a beta greater than one tend to increase and decrease in value faster and more quickly 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, then the Treynor Ratio is 2 (3 divided by 1.5). This means that in the past, the fund has given two units of return for one unit of its market risk.

Small investors, who are trying to make the most of their investments are often plagued by questions whether MFs are safe? Are they safer than direct equity investments?

MFs are an easier way for small investors to put money in the stock markets with low initial investment as they can get the benefit of any upswing in the prices of the shares because of the expertise of fund managers. However, small investors should be aware that since MFs in turn invest in shares, the returns are subject to the fluctuations of the stock market and are not fully insulated from it. The extent of risk, and also the returns come down with the inclusion of debt securities in the portfolio of MFs and investors should understand their risk tolerance before investing. MF investing can be a good alternative for small investors provided they tread with caution.

 (The writer is Assistant Professor, Amity University)