While most investors compare mutual fund returns with the benchmark index such as Sensex or Nifty, a diligent investor must analyse the impact of expense ratio and the risk taken to deliver the return.
Given the fact that only six out of 192 equity mutual funds gave double-digit five-year systematic investment plan (SIP) returns, it has become important for investors to look beyond the risk and returns parameters before investing in mutual funds. Look at expense ratio, risk adjusted returns and portfolio turnover as these can affect mutual fund investments.
An investor must look at the periodic disclosures fund houses provide to analyse these parameters instead of considering only the historical returns of the scheme. While most investors compare mutual fund returns with the benchmark index such as Sensex or Nifty, a diligent investor must analyse the impact of expense ratio and the risk taken to deliver the return.
As the net asset value (NAV) of a scheme is reported after accounting the expense ratio, a higher rate will reduce the returns from equity investments in the long run. The markets regulator has linked the total expense ratio— the fee that asset management companies collect from investors every year to manage their money—to the assets under management. Investors must evaluate if the actively managed fund justifies the higher expense and outperforms the benchmark at various market cycles.
With rising awareness, investors should look at direct plans which have a lower total expense ratio as compared to regular plans. As the NAV of a direct plan is higher than a regular plan, the difference in the returns between a regular and a direct plan will grow if one stays invested long-term. A switch from a regular to direct plan can be done by submitting a switch request form to the mutual fund house or Registrar and Transfer Agent.
Risk adjusted returns
It reflects the quantum of risk taken by the fund manager to earn the returns. Investors must look at this ratio as it gives a clear picture on the returns from a mutual fund scheme relative to the amount of risk taken over a period of time. If a fund manager is taking higher risks, it should earn higher returns to justify the risk taken. There are five measures that can be used to analyse the risk adjusted returns: Alpha, Beta, R-squared, Standard Deviation and Sharpe Ratio. The Sharpe Ratio shows how the asset performed. It is calculated by deducting return on risk-free instrument from the realised return and then dividing it by the standard deviation of the portfolio return. A higher Sharpe Ratio means that the investor has been better rewarded for the risk taken.
It is the churn in the mutual fund portfolio that the fund manager has made. A higher portfolio turnover means higher costs for the investor and will impact returns in the long-run. Funds having dynamic asset allocation have a relatively higher expense ratio. Experts say a higher churn many not always lead to higher returns, especially when the markets are very volatile. A higher churn is an indicator that the fund is underperforming.
A low turnover ratio indicates the fund manager is confident about his stock purchases and holds the stocks for a longer period. So, such a fund will have low transaction costs. Index funds have very low portfolio turnover as the fund manager invests in stock market indices in the same shares and in the same proportion. As the expense ratio of index funds is lower (10 to 50 basis points) than other actively managed funds of AMCs, returns generated can be higher in the long run.
So, if an investor notices steady increase in turnover ratio and not much increase in returns, then he should take a relook at the scheme and exit it at the earliest to minimise the losses.