Mutual Fund Analysis: What to Analyze

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Mutual Fund Analysis: What to Analyze

While most mutual funds claim to have processes in place for selection of instruments, what most cannot avoid is a preference bias and a style of investing. Since this may affect the choices you make for your portfolio, it is essential that you select funds which have an acceptable style and thesis.

We at Prabhudas Lilladher use a wide variety of tools and analyses to arrive at what we would consider essentials of analysis of funds and presenting these to our clients.

Using Appropriate Benchmarks
The first piece of information to analyze with mutual fund performance is the fund’s returns compared to an appropriate benchmark. If you notice that one of your funds had a divergent value from others in a given time frame, this is no indication that the declining fund should be removed from your portfolio. This requires the funds to be clustered in similar categories irrespective of what the fund says and understanding whether that benchmark or cluster is where you wish to invest.

Focus on Mid to Long Term Performance
Investing is a marathon, not a race; it should be boring, not exciting. Strong performance is not sustainable and in mutual funds, one prefers what is called consistent performance and not superlative.
Just as some fund managers are bound to have a bad year from time to time, fund managers are also bound to do better in certain economic environments, and hence extended time frames of up to three years, better than others. For example, perhaps a fund manager has a solid conservative investment philosophy that leads to higher relative performance during poor economic conditions but lower relative performance in good economic conditions.
Considering the fact that fund management styles come in and out of favor and the fact that market conditions are constantly changing, it is wise to judge a fund manager’s skills, and hence a particular mutual fund’s performance, by looking at time periods that span across differing economic environments.

Common time periods for mutual fund performance available to investors include the 1-year, 3-year, 5-year and 10-year returns.

Manager Tenure
Manager tenure must be analyzed simultaneously with fund performance. Keep in mind that a strong 5-year return, for example, means nothing if the fund manager has been at the helm for only 1 year.

The Greeks

While other factors listed above are more or less subjective, there are simple mathematical tools that one should use for analysis of funds
a) Alpha – Alpha is a measure of performance on a risk-adjusted basis. Alpha takes the volatility (price risk) of a mutual fund and compares its risk-adjusted performance to a benchmark index. The excess return of the fund relative to the return of the benchmark index is a fund’s alpha. In other words, Alpha tells you if the fund manager is worth what you pay him. – a positive Alpha is good, negative Alpha is bad.
b)Beta – Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole. Beta is calculated using regression analysis, and you can think of beta as the tendency of a security’s returns to respond to swings in the market- in other words, Beta is an expression of how volatile an investment is compared to the overall market.
c) Correlation – Correlation simply describes how two things are similar or dissimilar to each other. Specifically how two investments move in relation to each other, how tightly they are linked or opposed- so when you are looking for predictability or desired behavior you look at funds with strong correlation to the preferred index or benchmarks
R-squared (R2) is an advanced statistical measure that investors can use to determine a particular investment’s correlation with (similarity to) a given benchmark. For example, an R-squared of 100 indicates that all movements of a fund can be explained by movements in the index.
d)Sharpe Ratio

This ratio shows the return per unit of the total risk taken by the scheme. Higher than category average Sharpe ratio indicates that the fund manager was able to generate higher return per unit of total risk.

e)Treynor’s Ratio
This ratio indicates the return per unit market risk—also known as systemic risk—taken by the scheme.Higher than category average Treynor’s ratio indicates that the fund manager was able to generate higher return per unit of systemic or market risk.

Expense Ratio
Mutual funds do not run themselves. They need to be managed and this management is not free! The expenses to operate a mutual fund determine returns especially over long periods of time.
Never buy a mutual fund with expense ratios higher than these especially when selecting debt funds!
Number of Holdings
Typically, if a fund only has 20 or 30 holdings, volatility and risk can be significantly high because there are fewer holdings with a larger impact on the performance of the mutual fund. Conversely, if a fund has 60 or 70 holdings, it is so large that its performance is likely to be similar to an index, such as the Nifty. In this case, an investor may as well just buy one of the best index funds rather than hold a large-cap stock fund with the entire basket of the Nifty!
Turnover Ratio
The Turnover Ratio of a mutual fund is a measurement that expresses the percentage of a particular fund’s holdings that have been replaced (turned over) during the previous year. A low turnover ratio indicates a buy and hold strategy for actively-managed mutual funds but it is naturally inherent to passively-managed funds, such as index funds and Exchange Traded Funds (ETFs). In general, and all other things being equal, a fund with higher relative turnover will have higher trading costs (Expense Ratio) and higher tax costs, than a fund with lower turnover. In summary, lower turnover generally translates into higher net returns.
Style Drift
Style drift is a lesser-known potential problem for mutual funds, especially actively managed funds, where the fund manager sells out of one type of asset class and buys more of another type that may not have been part of the original objective of the fund. For example, a large-cap stock mutual fund may “drift” toward the mid-cap style if the manager sees more opportunities in smaller capitalization areas.
When doing your research, be sure to look at the history of the fund’s style.

Credit Rating

All debt papers that the fund invests in are rated by agencies according to their risk profile. While government securities are totally risk free, corporate papers are rated from AAA (highest safety) to D (default). High rating indicates that the fund is taking lower credit risk. Since investors go for debt investment to reduce risk, they should avoid schemes with too many low quality papers.

All of the above factors go into understanding which scheme is ideal and investors are advised to talk to their advisors regularly to get a grip on these and avoid surprises!

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