5 TOOLS TO EVALUATE MUTUAL FUNDS

5 TOOLS TO EVALUATE MUTUAL FUNDS

These statistical tools are used by fund managers to understand the risk-reward profile of a mutual fund. Though these involve complex formulae, you don't need to calculate all of them. Simply knowing the final figures and what the ratios indicate will help you analyse the fund.

1. STANDARD DEVIATION: It is a measure of a mutual fund's volatility.

HOW TO INTERPRET IT: It measures the degree to which a fund's return fluctuates in relation to its average return over a period of time. The higher the standard deviation, the more volatile the fund, and hence, more risky as the funds performance will rise and fall drastically in a short period of time.

KEEP IN MIND: Usually, as standard deviation increases, so does the return due to the risk-return trade-off. But if two funds with same investment objectives deliver similar returns, the one with the lower deviation is a better choice as it maximises the returns for the given risk level. So, while HSBC Equity and DWS Alpha Equity aim at capital growth from diversified stocks and have performed similarly, the latter has a higher deviation.

2. SHARPE RATIO: The ratio explains whether the fund returns are due to intelligent investment decisions or the result of excessive risk taken by the fund manager.

HOW TO INTERPRET IT: It is measured by subtracting the risk-free return from the fund's return and dividing the result by the standard deviation of its return. The risk-free return in India is considered either to be the bond rate or 181-day treasury bill rate. The higher the ratio, the better is the fund's risk-adjusted performance.

KEEP IN MIND: A fund may fetch higher returns than its peers, but it's usually a good option only if it doesn't take too much risk in doing so. Take Reliance Equity Opportunities and BNP Paribas Dividend Yield. The former multicap fund has earned higher returns, but it also has a lower Sharpe ratio.

3. BETA: It's also a measure of volatility and tells how risky a fund is in comparison to the market.

HOW TO INTERPRET IT: It measures the sensitivity of a fund's return to swings to the market. The market's beta is always 1. The index funds' beta value is equal to that of the market. If the beta is less than 1, it indicates less volatility than the market, and vice-versa.

KEEP IN MIND: Conservative investors whose focus is capital preservation should look at funds with low betas as their values are less likely to decline than those of the benchmark index in a bear phase. The table shows the performance of two funds relative to their benchmark (S&P CNX Nifty) during the bear phase -9 January 2008 to 5 March 2009. Birla Sun Life Asset Allocation Aggressive has a lower beta and fell less than the benchmark.

4. R-SQUARED: The ratio explains how closely a fund's performance correlates with the performance of the overall market.

HOW TO INTERPRET IT: It measures the percentage of a fund portfolio's movement that can be explained by the movement of benchmark index. R-squared values range from 0 to 1, where 0 indicates no correlation, while 1 indicates perfect correlation.

KEEP IN MIND: Avoid investing in the actively managed funds that have higher expense ratios and are still perfectly correlated with the index as it will be better to invest in an index fund. In the example, ING Large Cap Equity has the same R-squared as an index fund. The 3- year returns of the fund are only 0.5% higher than the index fund, while there is a differential of 1.5% in the expense ratio.

5. ALPHA: It quantifies what the fund manager brings or takes away from the return of an investment, which is based on his skill and value addition that he provides.

HOW TO INTERPRET IT: It is a measure of performance on a risk-adjusted basis. Alpha considers the price volatility of the fund and compares its risk-adjusted performance with that of the benchmark index. The excess return of the fund relative to benchmark index is called alpha. A positive alpha of 1 means that the fund has outperformed its benchmark index by 1%, and a similar negative alpha indicates an underperformance of 1%.

KEEP IN MIND: Funds with negative alpha are not good options as it means the fund manager is not generating any value-added return in excess of the market. The more positive an alpha, the better it is. In reality, few fund managers create a meaningful alpha that negates the expenses of the scheme. The table below shows that HDFC Top 200 has generated significant alpha, while UTI contra has not, and JM equity has created a negative alpha.

Source: www.wealth.economictimes.com

Thanks,

Gaurav Agarwal

Head Dealer

DENIP Consultants Pvt Ltd