Essential tools and metrics for mutual fund analysis

Investing in mutual funds is a significant step toward building wealth. However, evaluating mutual funds requires a clear understanding of certain metrics and tools. Let’s explore how you can analyse mutual fund performance, the importance of historical returns and ratings, and factors affecting returns to make informed decisions.

How to analyse mutual fund performance

Compare the fund’s performance with its benchmark and peers

A mutual fund’s performance should always be measured relative to its benchmark and similar funds in the same category. The benchmark represents the market segment that the fund aims to beat. If the fund consistently outperforms its benchmark and peers, it is generally a sign of efficient management.

Example: If a mid-cap fund consistently beats the Nifty Midcap 100 index and other mid-cap funds, it’s likely a strong performer.

Assess the expense ratio

The expense ratio is the annual fee charged by the fund for managing your investment. A lower expense ratio allows a higher portion of your money to stay invested and grow. However, it should not be the sole factor in decision-making.

Insight: While a lower expense ratio is desirable, a slightly higher ratio can sometimes be justified if the fund has strong, consistent returns.

Examine historical performance across market cycles

Reviewing a fund’s historical performance over periods like 1, 3, 5, and 10 years provides insights into its consistency. This helps gauge how the fund performs during bull markets and economic downturns.

Why it matters: A fund that manages to deliver stable returns across different cycles reflects strong management and a robust investment strategy.

Check the portfolio strength

Analyse the fund’s portfolio for diversification and quality. A well-diversified portfolio minimises risk. For example, a concentrated portfolio with heavy investments in one sector could experience significant losses during sector downturns.
For debt funds, check the credit quality and maturity profile of the securities to ensure stability.

Analyse risk-adjusted returns

Risk-adjusted returns highlight how well a fund compensates for the risks taken. Key metrics include:

• Sharpe ratio: Measures returns over the risk-free rate. A higher Sharpe ratio is better.
• Standard deviation: Indicates the fund’s return volatility. Lower volatility often suggests stable performance.
• Beta: Shows the fund’s sensitivity to market movements. A Beta below 1 indicates lower volatility than the market.

Look at the portfolio turnover ratio (PTR)

PTR indicates how often the fund manager changes its portfolio. A high PTR might suggest an aggressive strategy, leading to higher costs. On the other hand, a low PTR may signify a long-term focus. The ideal PTR depends on the fund type.

Importance of Historical Returns and Fund Ratings

1. Historical returns as indicators
   While past performance doesn’t guarantee future returns, it offers a concrete record to assess the fund’s consistency and resilience. Funds with stable long-term performance are more likely to perform well in the future.
2. Simplification through ratings
   Mutual fund ratings (e.g., 5-star or 4-star) simplify decision-making for investors. Ratings are based on quantitative (performance, risk) and qualitative (management efficiency) factors. A highly rated fund is generally considered superior.
3. Elimination of poor performers
   Ratings also help eliminate funds with inconsistent or weak performance. For instance, low-rated funds often indicate issues such as high risk or poor management strategies.
4. The dynamic nature of ratings
   Fund ratings are not static. Changes in ratings reflect shifts in performance or management quality. Keeping an eye on rating changes helps investors stay informed about the fund’s evolving prospects. 

Factors Affecting Mutual Fund Returns

1. Performance of securities in the portfolio
   The underlying securities directly impact a fund’s returns. For equity funds, stock performance and market conditions are crucial. A diversified portfolio across sectors and market caps can reduce risks during downturns.
2. Fund manager’s expertise
   The skills and strategies of the fund manager play a pivotal role. Experienced managers make informed decisions during volatile markets, protecting investor capital while ensuring growth. Choosing funds led by seasoned professionals is crucial.
3. Economic and sectoral shifts
   Government policies and sector-specific trends significantly affect fund performance. For instance, a favourable policy in the technology sector can boost funds heavily invested in tech companies. Conversely, adverse regulations may hurt fund returns.
4. Fund size and assets under management (AUM)
   A fund’s size can influence its performance. While a larger fund signifies investor trust, it may face challenges in managing assets efficiently as the size grows. For small funds, flexibility allows quicker adjustments to market conditions.
5. Cash flows of the fund
   Funds with consistent cash inflows benefit from stable investments. However, underperforming funds may face redemption pressures, forcing managers to sell assets at unfavourable times, and impacting overall returns.
6. Expense ratio
   A fund with a high expense ratio might generate lower net returns, even if gross returns are strong. Always weigh expense ratios against the fund’s historical and risk-adjusted performance.

How to Compare and Evaluate Funds

1. Expense ratio
   Lower expense ratios are preferable but should be assessed alongside performance. For instance, a fund with a 0.5% expense ratio and 10% annual returns is better than one with a 1% ratio and 8% returns.
2. Investment objective alignment
   Select funds based on your financial goals. Equity funds are ideal for long-term growth, while debt funds suit short-term stability. Ensure the fund’s strategy matches your investment horizon.
3. Mutual fund performance comparison
   Always compare funds within the same category (e.g., large-cap funds). Check whether they consistently outperform their benchmarks and peers.
4. Risk profile
   Choose funds aligned with your risk appetite. For instance, aggressive investors may opt for equity-heavy funds, while conservative investors might prefer balanced or debt funds.
5. Asset under management (AUM)
   Funds with large AUM signify investor confidence. However, overly large funds might struggle to deliver higher returns due to reduced flexibility in reallocating investments.
6. Exit load
   Evaluate the cost of early withdrawals. High exit loads can impact returns if you need liquidity before the recommended holding period.
7. Benchmark comparison
   A fund consistently beating its benchmark indicates strong management. Benchmark comparisons help identify well-managed funds over market cycles.
8. Years in existence
   Older funds with a proven track record offer valuable insights into consistency and management quality. New funds, while promising, may carry higher uncertainty.

Conclusion

Analysing mutual funds involves examining multiple metrics, from historical returns to expense ratios and portfolio quality. By leveraging tools like ratings, benchmarks, and risk metrics, you can make well-informed decisions tailored to your financial goals. Mutual fund analysis requires patience and diligence, but the effort ensures you invest in funds that align with your objectives while minimising risks.