By Varun Fatehpuria
Investors frequently pursue only high returns, a tendency that becomes more pronounced in a bull market. While returns hold significance, they are not sacrosanct. We need to understand the period in which those returns were generated, how much risk the fund manager took when achieving those returns and what is the likelihood that the performance will sustain in the future.
Here are three essential alternative metrics to consider when evaluating funds in a more holistic manner:
Rolling returns
If you prioritise returns, rolling returns are preferable. Trailing returns, which gauge the return between two specific dates, offer an inadequate indication of a fund’s performance. There’s little assurance that you can replicate the same future return since that performance occurred during a very specific time frame. Rolling returns, however, are superior as they measure the consistency of a fund’s generated returns.
For instance, a one-year rolling return over 10 years displays the fund’s performance across multiple one-year periods within those 10 years. This approach sidesteps the bias of trailing returns and provides a more accurate assessment of the fund’s consistent performance. Consequently, it allows for a more reliable estimation of the potential return range if you invest in the fund for one year.
Downside capture ratio
The downside capture ratio serves as a strong indicator of a fund’s ability to safeguard itself in a bearish market. A ratio under 100 signifies that the fund’s losses are less severe compared to its benchmark, while a ratio above 100 suggests greater underperformance. All else being equal, this ratio is among the most crucial factors to consider when evaluating a fund. This is because the likelihood that the investor will stay invested and continue investing over the long term increases when it outperforms the index during periods of volatility.
Max drawdown and recovery period
Similar to the downside capture ratio, the max drawdown/ recovery period is a measure of risk. It quantifies the most significant decline in a fund’s value from its peak to the lowest point before a new peak is achieved. And the time taken to reach a new peak from the trough. A lower drawdown/recovery period signifies better downside protection for the fund.
Assume you invested at the market’s peak, and the market begins to decline. The max drawdown calculates the percentage decrease from the peak to the trough. It demonstrates the worst potential loss if you invested at the peak and sold at the bottom. The higher the max drawdown, the greater the effort in recouping the losses.
While investors often succumb to the allure of high-returning stocks or funds, it’s crucial to recognise psychological biases during the investing journey. Managing one’s emotions and actions during market downturns significantly enhances the ability to generate higher future returns. As sthey say, it’s rarely about making the most when markets are climbing than it is about losing the least when markets go down.
The writer is founder, Daulat