‘Mutual Fund investments are subject to market risks.’

 

We’re all familiar with this caveat. Mutual funds are not products that generate fixed income. They are risky, and market circumstances influence their performance. Furthermore, past results do not guarantee future results. As a result, while analysing a mutual fund, one must consider factors like asset allocation, investment strategy, and other factors, giving a more complete picture of the fund.

 

Performance evaluation of mutual funds is an essential aspect of investing in them. Evaluating mutual fund performance requires a comprehensive analysis of historical performance, fund manager track record, investment philosophy, degree of diversification, investment style and expense ratio and risk-adjusted returns.

 

However, the world of finance is loaded with technical concepts and complicated terminology. In some cases, the words may sound impressive; in others, they are intimidating or confusing. Worse, some of the vocabulary isn’t what it sounds like. Financial jargon can make it difficult for investors to understand the underlying concepts, leading to confusion. As a result, it is essential to simplify financial jargon and provide clear explanations for novice investors to understand.

 

This article attempts to demystify some basic measures of mutual fund performance that can help make informed decisions and avoid costly mistakes. Without performance evaluation, one is often in the dark about their investment’s true value and the associated risks.

 

As stated by Bill McNabb, the world’s largest mutual fund manager, “Measuring performance is not just about returns; it’s about assessing how much risk was taken to achieve those returns.”

 

Let’s start with risk, as it naturally comes to the forefront when evaluating mutual fund performance. Various risk measures, such as standard deviation, Beta, R-squared, and maximum drawdown, are employed to assess the level of risk undertaken.

 

Standard Deviation measures the degree to which the fund’s returns have varied from the average return over a specific period. A higher standard deviation means that the fund’s returns have fluctuated more, indicating a higher level of risk.

 

Beta measures the fund’s sensitivity to market movements. A beta of 1.0 means that the fund moves in line with the market, while a beta greater than 1.0 indicates that the fund is more volatile than the market.

 

R-Squared measures the degree to which the fund’s performance is explained by its benchmark index. A higher R-squared means the fund’s performance is more closely tied to its benchmark. In contrast, a lower R-squared indicates that other factors drive the fund’s performance.

 

Maximum Drawdown measures the largest loss the fund has experienced from its peak value to its lowest value during a specific period. A higher maximum drawdown indicates that the fund has experienced larger losses, indicating higher risk.

 

We all want significant returns with little risk, which makes analysing risk-adjusted returns vital in mutual fund investing. They provide a more accurate picture of the fund’s performance than just looking at raw returns. Raw returns do not consider the amount of risk assumed to achieve those returns. Mutual funds invest in various assets, including stocks, bonds, and other securities, carrying different levels of risk. Risk-adjusted returns provide a measure of how much return an investor is receiving per unit of risk taken.

 

Analysing risk-adjusted returns help in comparing the performance of different mutual funds with similar investment objectives and asset allocations. Suppose two mutual funds have the same raw return, but one has a lower risk-adjusted return. In that case, the fund with the lower risk-adjusted return takes on more risk to achieve the same return.

 

Some of the measures of risk-adjusted returns are Jensen’s Alpha, Sharpe Ratio, Treynor Ratio, Sortino ratio and Information ratio.

 

The Jensen Alpha, also known as the Jensen’s Performance Index, was developed by Michael Jensen in 1968. The metric measures a portfolio’s excess return over the expected return based on its Beta (systematic risk) and the market risk premium (the difference between the expected return on the market portfolio and the risk-free rate). This measures the fund’s excess return relative to its benchmark index. A positive Jensen Alpha indicates that the portfolio has outperformed its expected return given its level of systematic risk. In other words, a positive alpha suggests that the fund has outperformed its benchmark index, while a negative alpha indicates underperformance.

 

The Sharpe Ratio was developed by Nobel laureate William Sharpe in 1966. The ratio measures a portfolio’s excess return over the risk-free rate (G sec rate) per unit of volatility or risk (as measured by the standard deviation of the portfolio’s returns). The Sharpe ratio measures a fund’s excess return per unit of total risk. It is calculated as follows:

 

Sharpe Ratio = (Portfolio Return – Risk-Free Rate) / Standard Deviation

 

The higher the Sharpe Ratio, the better the portfolio’s risk-adjusted performance. The Sharpe ratio is more appropriate for evaluating the performance of all types of mutual funds, including those with low or non-existent beta values, such as bond funds or fixed-income funds. The Sharpe ratio can also help compare funds with different investment styles or evaluate a fund’s performance over shorter periods.

 

The Treynor ratio was developed by Jack Treynor in 1965. It measures a portfolio’s excess return over the risk-free rate per unit of systematic risk (as measured by the portfolio’s beta). Systematic risk is the risk that a diversified portfolio cannot diversify away.

 

Treynor Ratio = (Portfolio Return – Risk-Free Rate) / Beta

 

The higher the Treynor Ratio, the better the portfolio’s risk-adjusted performance.

 

The only difference between the Sharpe ratio and Treynor is the risk measure. Therefore, the Treynor ratio is most appropriate for evaluating the performance of well-diversified portfolios with exposure to systematic risk. It is most useful when comparing mutual funds with similar investment styles or when assessing the performance of a single fund over a long period.

 

The Sortino Ratio is similar to the Sharpe Ratio but only considers downside risk. It measures the excess return of the fund relative to the downside deviation of its returns. It is calculated by dividing the excess return of an investment over the risk-free rate by the downside deviation of the investment. The downside deviation is calculated by measuring only the negative returns or returns below a specified threshold.

 

Sortino Ratio = (Portfolio Return – Risk-Free Rate) / Downside Deviation

 

A higher Sortino ratio indicates better risk-adjusted returns. The Sortino ratio is beneficial for evaluating investments that have significant downside risk. For example, it may be appropriate to use the Sortino ratio to assess the performance of a hedge fund or other investment strategy that seeks to limit downside risk. By focusing only on the downside deviation of returns, the Sortino ratio provides a more accurate picture of how well an investment manages risk concerning its returns. Therefore, more risk-averse investors often use it to avoid assets with high downside risk.

 

The Information Ratio measures the risk-adjusted excess return of a fund relative to a benchmark. It compares the fund’s excess return to the tracking error or the difference between its and benchmark returns. A higher Information Ratio indicates better risk-adjusted performance.

 

The information ratio is best used when evaluating actively managed funds or portfolios designed to outperform a benchmark. The information ratio helps to determine whether a fund is generating excess returns relative to its benchmark and whether this outperformance is due to skill or luck. The higher the information ratio, the more likely the fund’s outperformance is due to skill. Therefore, it is often used by investors seeking active management and looking to evaluate the performance of their fund managers.

 

Other than focusing on risk and return, analysing the fees and expenses associated with the fund is essential to ensure they are reasonable and do not eat into the investor’s returns.

 

The expense ratio of a mutual fund is an essential factor to consider when evaluating its performance because it represents the fund’s annual operating expenses, including management fees, administrative costs, and other expenses. Thus, the expense ratio is the annual fee charged by the fund manager to manage the fund. It is expressed as a percentage of the fund’s assets under management. A high expense ratio can eat into the fund’s returns, reducing the overall performance for investors. A lower expense ratio is generally better because it leaves more money in the fund to be invested. Over time, even minor differences in expense ratios can significantly impact returns.

 

With the increasing popularity of index funds, it is vital to build the right toolkit for analysing them. In addition to the above-mentioned risk and return measures, investors should look for tracking error and turnover ratios.

 

Tracking Error measures how closely the fund tracks its benchmark index. It is calculated by taking the difference between the fund’s and the benchmark index’s returns. A lower tracking error indicates that the fund is doing a better job of tracking the index.

 

The Turnover Ratio measures how frequently the fund’s holdings are bought and sold. It is expressed as a percentage of the fund’s assets under management. A higher turnover ratio can result in higher transaction costs and capital gains taxes, eroding returns over time.

 

These measures are all used but differ in the emphasis given under different situations. For example, the Sharpe ratio is suitable for investors concerned about downside risk and who want to minimise the probability of negative returns. On the other hand, the Treynor ratio is helpful for investors concerned about their investments’ systematic risk. There is no one-size-fits-all answer to this question, as the choice of the best measure for MF risk-adjusted performance depends on various factors such as the investment objective, investment horizon, risk tolerance, and investment style of an individual investor.

 

After reading this article, I don’t want you to evaluate your investment every day or whenever the market crashes. Remember, markets move in cycles. Only when you invest long, you can expect to see significant profits. As a result, you should evaluate and study the performance of your mutual funds every six months to a year. As thematic or sectoral funds are more vulnerable to market conditions, you may need to review them more frequently than other funds.

 

Keep a look out for funds that are underperforming the benchmark. Before you decide to exit, monitor the performance of such funds for two to three quarters. An extended period of underperformance hints that you should sell your investment. It would be best if you also comprehended the cause of such underperformance. The fund management routinely buys and sells equities, altering the portfolio’s makeup and risks. The risk parameters are critical for assessing the performance of a fund. If the fund’s risk profile has drifted further towards ‘High’ risk while returns have stayed constant or declined, it may be advisable to quit the fund. Furthermore, funds that perform well today may not generate significant returns in the future. As a result, you should review your portfolio regularly.

 

To conclude, with the words of the Oracle of Omaha:

 

“Investing without evaluation is like driving with your eyes closed.”

 

So my dear readers, Enjoy being in the driving seat on the journey of financial prosperity!! 

Best Regards

 

Dr. Tarunika Jain Agarwal Ph.D. 

 

Alpha Research