Investing in mutual funds has an inherent risk assumed upon the ownership. However, performance of the mutual funds can be quantified with the help of the below mentioned tools.
Often, investors are confused about the evaluation of the performance and quality of their mutual funds because assessing the performance by means of rate of return alone is not an appropriate measure. Let us discuss some basic measures to be used while assessing the performance of your mutual funds.
Compare with benchmark index
Always compare the performance of your mutual fund to other similar funds or a corresponding index. For instance, let us assume that you have invested in a mutual fund which invests only in mid-cap shares listed on the National Stock Exchange. While assessing the rate of return of your fund, you should compare the same with the returns generated by mid-cap index of the market which is a benchmark. If you have invested R10,000 on the above fund, how have the benchmark and your mutual fund performed over the same time frame? If the benchmark index returned 52% whereas the mutual fund returned 24% then the return from the mutual fund is not good. Benchmarking is a point of reference compared to the funds peer markets and it helps you to evaluate the performance of your investment against the market competition.
Relative performance with peers
Another yardstick used is comparing your fund’s performance against its peer group. This yardstick indicates the effectiveness of your mutual fund of the same category. While choosing a peer group you have to ensure that the peer should have a similar mandate. For instance, you have invested your money in a large cap fund of ABC company then you have to choose a peer fund company which is also investing in large cap fund only. If your fund bested its peers, then it is a good fund but the caveat is that it not always possible to identify a similar comparable peer group.
Risk adjusted returns
It is used to compare the returns of mutual funds with different risk levels against a benchmark with a known return and risk profile. Because, risk-adjusted return refines a fund’s return by measuring how much risk is involved in producing that return, which is generally expressed as a number. It measures how much return your mutual fund made relative to the amount of risk the investment has taken over a given period of time. If compared, a couple of mutual funds which drive the same percentage of returns over the same period of time, the lesser risk funds have a higher risk adjusted returns. Popular risk adjusted return measures are Sharpe and Treynor and Jensen’s Alpha.
This ratio was developed by Nobel Laureate William Sharpe and it quantifies a fund’s return in excess of the risk-free or guaranteed return (90-days Treasury bill) relative to its standard deviation. It is computed as fund’s return minus risk free rate divided by standard deviation return of the fund. The higher a mutual fund’s Sharpe ratio, the better its returns have been relative to the amount of investment risk it has taken.
The Treynor Ratio named after Jack L Treynor, helps to analyse returns in relation to the market risk of the fund. It is also known as the reward-to-volatility ratio. It provides a measure of performance adjusted for market risk. It is similar to the Sharpe Ratio, except that it uses beta as the volatility measurement. The ratio divides the difference of return of a mutual fund and the risk free rate by beta of the fund. Therefore it tells us the return per unit of market risk. Higher the Treynor Ratio, the better is the performance under analysis.
The Jensen’s Alpha was propounded by Michael Jensen who is a well-known economist. It is determined by taking the mutual fund return and subtracting the expected return according to capital asset pricing model. For every investor, it is important to understand the risks they would be taking when they invest in a particular mutual fund. This means that between two mutual funds that are offering similar returns, the one with less risk would be more lucrative for investors than the one with higher risk. The Jensen’s Alpha help you determine if the return an asset is generating on average return which is acceptable compared to the risks it is offering. A positive alpha indicates that it generated return which is more than that of its risk and vice-versa.
Investing in mutual funds has an inherent risk assumed upon the ownership. However, performance of the mutual funds can be quantified with the help of the above tools.
The writer is associate professor of finance & accounting, IIM Shillong