In an earlier blog (https://www.plindia.com/blog/the-abcs-of-mutual-fund/) we had highlighted the various factors that should be taken into account while selecting mutual funds. However, when faced with a choice between let’s say 3 funds within a category, how does one zero down to the particular one?
Of course, and without laboring on, one must select fund houses which have a reasonably long and consistent track records apart from a strong parentage- this would ensure processes and capability which should ideally result in performance over a period of time.
However, all things being equal between the 3 funds, one has to then scrutinize the performance broadly on risk and return using some basic rules (and not returns alone!)
Measuring Risk and Return
Has the fund taken above average risk to generate returns in the past? If yes, it would show up as something called “standard deviation of returns” – essentially meaning that the higher risk would have resulted in higher volatility of the NAV over a period of time – of course the risk may have been conscious – like taking concentrated bets or jumping into contrarian bets etc- (or may not! Like having bought a substantial portion in a stock that went its own way suddenly ) been but the fund manager should have compensated this by additional returns ideally. So if two funds took equal risk, the one with the better returns should be preferred.
This in essence is what the “Sharpe ratio” (https://www.plindia.com/blog/mutual-fund-ratios-what-they-mean-and-how-to-use-them/) measures – returns divided by risk- in effect giving a number that shows which fund generated better returns per unit of risk.
However, the ratio brings all funds down to an “equivalent” measure of risk – so its ideal for investors who want the lowest possible risk for a given return. What about investors who prefer funds which can beat their benchmarks irrespective of risk involved?
This brings us to the second concept called Alpha – the simplest definition of Alpha is the excess return of a fund compared to its benchmark index. If a fund has an alpha of 10%, it means it has outperformed its benchmark by 10% during a specified period. However, instead of using just the benchmark return, what if the benchmark return was adjusted by the additional risk that the fund manager took – this is achieved by adding something called a Beta to the mix. Beta measures a fund’s volatility compared to that of a benchmark. A fund with a beta of 1 means, it will move as much as the benchmark. If a fund has a bet of 1.5, it means that for every 10% upside or downside, the fund’s NAV would be 15% in the respective direction.
Therefore, did the fund manager , who had a beta of 1.5 , deliver above 15% and the one who had a beta of 1.1 deliver at least 11%? All this number crunching is done with the help of a measure called Jensen’s Alpha (Read more about it at https://www.plindia.com/blog/what-is-the-jensens-alpha/)
Prabhudas Lilladher MF Recommendations
So what if you had a fund that gave a) higher risk adjusted returns – ideal for investors looking for least risk for a return – as well as b) Alpha – ideal for people chasing momentum. The fund manager was in effect being asked to keep risk minimal for a return but also ensure returns were higher than the risk adjusted benchmark.
Obviously both may not always be possible all the time so what if one looked for maximum appearances in the honors list – so either the risk was tuned down at times or higher risk was taken but whatever happened, the fund manager compensated with performance?
PL Recommendations on mutual funds take into account both these criteria for client recommendations as well as advising Investactive MF – only funds which qualify on both these criteria across 2, 3 and 4 year timeframes are recommended to clients so as to ensure only the best are invested into!
Our proprietary system blends these ratios and selects funds that are consistently appearing in these criteria – so consistency apart from performance is taken into account.
One could have churned out N number of ratios but sometimes simplicity itself is enough – as long as we know the fund’s ABCs – Alpha, Beta and Consistency, other ratios may not throw up much value except keeping analysts busy!
I am a stock pro – I look at Current Portfolios to decide
Investors in stocks often end up asking – why should I not look at the current portfolio of the fund house and decide whether its aligned to my view?
And our boring answer to that – Why hire a fund manager, pay so much in expenses and fees, to eventually buy the same thing you can anyways buy into your trading account? The idea of buying a fund (actually, at least 3 of them) is to bring differing opinions and diversify styles for long term wealth accumulation. Remember – a fund is to be held for 3 years minimum and a lot can happen in that timeframe. You trade your own stocks and let the fund manager do his own thing!
Don’t some of us track fund houses to see what they are buying and then sometimes buy for ourselves- then why reverse the process?
Remember : Regular Reviews
Unlike stocks, where you may take a long term view irrespective of short term performance and volatility, the fund manager’s potential performance is not displayed by either his past performance or his current portfolio.
No matter how many ratios you churn out, remember that he (or the fund’s investment committee) may change their stance on markets or sectors or stocks and this would show up over a period of time in NAVs – there is no guarantee that the “best funds” of the past would deliver highest returns in the future as well – therefore a regular review (we recommend quarterly) is essential , to check whether the fund house is displaying continuing consistency or has performance started deteriorating/ drifting.
Our MF Desks are available at your service (email@example.com) and you may wish to check with us on our latest recommendations or send us your portfolios for a free -no obligation review!