Mutuals funds are a convenient method to automate your investments especially when you are just beginning. (Read here to know why I insist you MUST start with mutual funds). They are also very easy to start and remove much of the hassle of individual stock picking. You can start with passive mutual funds right away, but if you plan to put your hard-earned money into active mutual funds, it would be wise to learn how to analyze active mutual funds and choose which one would be the best.
I often see people putting their money into funds only because their agents told them to. They know nothing about the fund, sometimes not even the full name. Often, after I talk to them, I go and check the performance of these funds and find out that many of them never even beat the index. Add to that the bad news that they are generally very expensive. (Which might be why they were recommended by agents in the first place). The result is poor returns and high fees.
It is thus important to analyze mutual funds yourself before putting your money in. The right way to choose mutual funds is not much different from choosing a company. Just like you would try to understand the growth prospects of a company by understanding its strategy, its management, its product and market, you should analyze the growth prospects of a mutual fund by understanding its investing strategy. Since the returns from a mutual fund are dependent on the stocks it selects, you should understand how the mutual fund selects its stocks. Some mutual funds select growth stocks which are in an uptrend, while some other funds choose value stocks; some fund houses prefer to keep on changing their stocks pretty quickly (known as churn) while some stay with their stocks for a long time. Understanding the investing strategy is key to understanding a fund. This can easily be found on the website of the mutual fund.
Though there is no alternative to understanding the investing strategy of a mutual fund, an additional way to analyze mutual funds is to understand their past performance. Just like there are financial ratios to give you a summary of a company’s financial performance, like Price to Earning ratio, Debt to equity ratio, Return on Equity (ROE), Return on Capital Employed (ROCE), there are a few measures to analyze mutual fund performance. These are not a substitute to understanding the investing philosophy of a mutual fund but these measures can give you an idea about the fund's past performance and help screen the good ones from the bad.
Let us look at five of the most important measures below:
1. CAGR:
The only reason we invest in a mutual fund is to generate returns. So the most important thing to look at is the CAGR (Compounded Annual Growth rate) of a mutual fund. Say, the CAGR of a mutual fund is 15%. It means it has been able to generate 15% returns each year on average.
Higher the CAGR, better it is (duh!)
Be sure to look at CAGR of various time periods, such as 1 year, 3 years, 5 years.
Compare with other mutual funds in the same category
Also look at the corresponding benchmark index. If the fund has been able to beat the index more often than not, it is a good fund.
Consistency is key. One time wonders are hardly in your benefit
2. Alpha:
One reason why we choose active mutual funds over passive funds is our hope that active funds will generate better returns than the benchmark index. We pay the mutual fund house higher money for the same expectation. Alpha helps us check if a mutual fund has actually been able to do this.
Alpha is indicated as a number like 2, 3, -4.5 and so on. It actually is the percentage difference in performance between the active mutual fund and the benchmark. So an alpha of 3 means 3% better performance than the index. If the corresponding index gave 15% returns, the mutual fund gave 18% returns.
A 2 or 3% difference may seem small at the outset but remember that with the power of compounding and can affect your returns quite significantly
Higher the positive alpha, the better
But be sure to look at beta along with alpha.
3. Beta:
While alpha indicates the ability of a mutual fund to beat the index, beta represents the risk it takes to do so.
The beta for benchmark is 1. Any number less than 1 means the mutual fund is less volatile than the index, meaning it is more reliable to generate good returns. A beta of more than 1 means the fund is more volatile than the benchmark. This means that the fund can generate both higher and lower returns than the benchmark. If the beta is 1, which it will be for index funds, it means the fund exactly with the index. If the index goes up 10%, the fund goes up 10%.
Lower beta means lower volatility. So it may not give you a lot of downsides on bad days but it also does not give you superior returns on the good days.
Low beta, high alpha indicates the fund is able to beat the index while taking lesser risk
Beta isn’t as straightforward as alpha. High alpha is always good. But high beta may or may not be right for you depending on your investing approach.
Choose low beta funds if you are risk averse. High beta can give you higher returns on good days. Choose high beta if you are ready for some risk.
4. Standard deviation:
Standard deviation in investing has the same meaning it has in statistics. Just like in statistics, standard deviation in investing measures how spread out from the mean the returns of a fund are. And since the “mean” in investing is the benchmark, standard deviation shows how away from the benchmark the fund performs.
Higher the standard deviation, more “spread out” the fund returns are
Since spread out can be both in positive and negative, high standard deviation shows how much better or worse a fund performs with respect to its benchmark
Essentially, it shows the riskiness or volatility of a fund.
More the SD, more is the possibility of both gains and losses of the fund.
Read it along with beta and higher SD for beta less than 1 is a good sign.
5. Sharpe Ratio:
Any sane investment strategy in active mutual fund should be to provide excess return to the unitholders. (Represented by alpha). But this should not come at the cost of higher risk (Represented by Standard Deviation). If a mutual fund takes too much risk for a bit higher return, the chances of blowing up increase too. A unitholder likes higher returns with lower risk.
Sharpe ratio is a ratio of these exact two things: Excess Returns / Risk (SD OF Excess returns)
Higher the Sharpe ratio, higher is the excess returns over the risk
So a higher Sharpe ratio is better for your mutual fund
Bottom line:
Mutual funds can be analyzed like companies using their past performance. The risk measures mentioned above can help you check how the fund has performed in the past. This helps select the good funds from the bad.
A summary of good performance: High CAGR, large alpha, beta less than 1 if you are risk averse, low standard deviation, high Sharpe ratio.
Remember, these measures show only the past performance. Use these for screening only. Once you have picked the good ones, be sure to analyze the mutual funds just like you would analyze a company. Focus on the investment strategy, its fund managers, the credibility of fund house, etc.
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