How to analyze Mutual Funds

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Analyzing Mutual Funds

Let me preface this by making it clear that predicting is hard, especially the future.

I’ve been reading up on how to evaluate a mutual fund and most of what I’ve read points to these metrics (in no particular order):

  • Expense Ratio
  • Fund Manager Experience
  • Fund Manager Tenure with the current fund
  • Turnover Rate
  • Sharpe Ratio
  • Sortino Ratio
  • 10-year and 5-year performance

FUND MANAGER EXPERIENCE AND TENURE LENGTH: Fund managers need to have a good track record over a long period of time. A lot of people will outperform markets over a shorter time frame but prooving consistent result over a longer period of time is the real test of a fund manager.

A form is temporary, the class is permanent.

It is also important to note how long this fund manager has been managing the fund if the fund is churning through its manager often. This might not give managers enough time to develop a sound long-term strategy and incentivize them to take unnecessary risks to meet short-term targets.

TURNOVER RATE: The inverse of a fund’s ‘turnover ratio’ is the average holding period for a stock in that fund. It is derived by dividing 100 by the turnover ratio.

So, a fund with a portfolio turnover of 50% would hold a stock for 2 years on average. Funds with lower turnover ratios tend to outperform funds with high turnover ratios.

EXPENSE RATIO: Keep fees low. Look for low-cost mutual funds or index funds. These have a huge impact over the longer term.

Here is a graph that assumes Rs 10,000 to grow 12% every year(average historic returns of Indian markets) for 20 years. Person A invests in a fund with an expense ratio of 0% Person B invests in a fund with an expense ratio of 2% Person C invests in a fund with an expense ratio of 2.8%

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Person A will have 30% more than Person B and 43% more than Person C.

Compounding will steal your returns, so seek funds with low expense ratio.

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Photo by William Iven on Unsplash

RISK METRICS 1 – SHARPE RATIO: Technical definition: The Sharpe ratio is the average return earned in excess of the risk-free rate per unit of total risk. Generally, the greater the value of the Sharpe ratio, the more attractive the risk-adjusted return. Look for fund who has high rewards for the risk you are taking, i.e funds with higher Sharpe Ratio.

RISK METRICS 2 – SORTINO RATIO: Sortino Ratio is a variation of Sharpe ratio but it only considers downside risk. Just like the Sharpe ratio, a higher Sortino ratio is better. When looking at two similar investments, a rational investor would prefer the one with the higher Sortino ratio because it means that the investment is earning more return per unit of bad risk that it takes on.

10-YEAR AND 5-YEAR PERFORMANCE: Numerous studies have found that over long periods fund performance tend to revert to mean. This would mean that fund which has performed great in recent years might perform poorly as it moves towards its performance mean. Looking at 10-Year and 5-Year performances show if the fund has been performing well over long periods or just recent years.

Here is a table showing the above metrics on some mutual funds.

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Some observations from the table on funds I found interesting:

Tata Equity PE: The fund has a low expense ratio and scores high on risk metrics. Turnover rate is decent but the fund manager is new and needs to be vetted during difficult times.

HDFC Smallcap: This fund scores high on all metrics. Manager tenure is only 4 years with the fund but his industry experience compensates for that. Seems like a safe bet.

ABSL Pure Value: High returns over long-term, good manager experience

SBI Smallcap: This has good risk metrics and phenomenal returns over 5 years. This fund is too young and has a high expense ratio. Although, the manager seems to have a good track record. This can be a good speculative bet.

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