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How to look at mutual fund returns

August 13, 2020

Our earlier article on using data looked at some of the wrong ways that investors tend to interpret mutual fund returns. In this one, we’re talking about areas where you are getting it right. Plus, a little more into how you can do better and go a few steps further.

#1 Comparing mutual fund returns with other funds

Among the many queries and responses we get, one that features quite frequently is why we have one fund recommended when another is doing well, or whether you can move from one fund to another that’s doing better. And that’s a great way to look at returns because a fund that’s able to beat both market and peers is a good one to have. In our analysis and ratings, comparing against its category is among the metrics we use.

But how you make such comparisons is the key.

  • One, compare with the right peers. Unless the funds are similar by nature, comparisons will lead you to incorrect conclusions. For example, you could look at – say, DSP Strategic Bond’s 15.4% 1-year returns now and see that against Kotak Corporate Bond’s 10.2% and wonder if you should move to the better fund. But the DSP fund is dynamic and currently has a duration strategy to gain from yield rallies, while the Kotak fund is more of an accrual fund with limited room for such price gains.
  • Two, know what in the fund’s strategy is causing it to move ahead. If it is a focused fund, for example, it could be a few stocks rallying that is driving returns. Cash calls in some equity funds could help in a volatile market. JM Large-cap, for example, has better 1-year returns than even Axis Bluechip. But that’s because the fund has gone up to 30% in debt over the past 12 months.
  • Three, don’t be short-term. Don’t look at 1-month returns or even 3-6 month returns and conclude that one fund is declining while the other is improving. Short-term returns have more to do with market dynamics than underlying fund strategies going wrong.
  • Four, look for consistency in the trend. An otherwise good fund falling behind its peers for a short while is nothing to worry about nor one on which you should act. Likewise, unless a fund has steadily pulled ahead of its peers and stays there, it may not be a good opportunity. The JM fund from above, for instance, beats peers less than 30% of the time when rolling 1-year returns since 2016. (Update: You can find rolling returns of many funds here in our rolling returns tool)

Compare mutual fund returns where the funds are similar. Look for consistency in the trend and look beyond the short-term period.

#2 Understanding poor performance drags your portfolio

A good part of queries we answer are when you use our MF Review Tool to identify what to do with your underperforming funds. You recognise and acknowledge underperformance but when to take action appears to be the challenge for you. (We have covered portfolio review in depth already).

When the fund’s share in your overall portfolio is low, whether you move out on not is not very material – though it is prudent to simply clean up, taxes or not.

But in other cases, where your underperforming fund accounts for say 20% or more of your portfolio, we see many of you being averse to making changes despite knowing that your fund isn’t doing much for your portfolio. While it is important to know the ‘why’ of underperformance in such cases, not acting can be double whammy. One, you are sitting with an underperformer. Two, it is concentrated and is therefore going to pull down your entire portfolio if it does not revive. And in the case of debt, such concentration may also spell capital risk.

Looking at the nature or the characteristics of a fund’s returns gives you a better understanding of a fund.

#3 Looking at metrics like standard deviation and Sharpe

These are metrics that measure how volatile a fund’s returns are and how well it delivers over the risk-free rate. We have had many of you asking us how funds and indices compare on their Sharpe ratios. All good! Looking at the nature or the characteristics of a fund’s returns gives you a better understanding of a fund.

When using metrics such as these, as well as others such as alpha, Sortino and information ratio, know the following:

  • There is no simple thumb rule to apply. It depends on the category itself – most accrual-based debt funds, for example, have high Sharpe ratios as their return deviations are low while dynamic bond funds could have lower Sharpe figures. For small-cap equity funds, a prolonged correction can send their returns lower than the risk-free rate which makes the Sharpe an irrelevant metric at times.
  • Don’t look at these metrics in isolation. A high standard deviation, while indicating that the fund is volatile, is not a deterrent if its long-term margin of outperformance and consistency in outperformance is strong. Mirae Asset India Large Cap, for instance, has a higher than average standard deviation, but is yet among the most consistent large-cap funds.
  • Stick to one source for information on these return ratios. That’s because these ratios use returns over a time period and at a particular frequency. Between providers, the time periods and frequency used in calculating the ratios will vary.

Fund performance and market performance always throw up trends. In March this year, for example, we had several queries on returns of liquid funds slipping sharply while those of ultra-short and similar very short-duration funds turned more volatile. Noticing such movements and trying to understand the reasons for it is important because it allows you to take action on your portfolio if needed. The credit crisis sparked many of you into analysing your own fund to check whether it had more risk than you could take.

However, not all trends are actionable. Trying to catch every trend can lead to frequent changes in your portfolio or lead you to invest in funds that you don’t understand. For example, pharma funds rallying sharply catches your attention – and you therefore invest in these funds or look for equity funds that have pharma exposure. That is not always the best idea. Similarly, you may want to make allocations to US funds expecting the current strong returns to sustain. But these funds are best used as diversifiers – i.e., allocations should be limited – and for long-term portfolios only, given that it is still equity.

Not all trends are actionable. Trying to catch every trend can lead to frequent changes in your portfolio or lead you to invest in funds that you don’t understand.

#5 Comparing with other options that offer better returns

Many of you ask us about alternative options to invest in, especially when they appear to offer better return opportunities. This is a good practice. We would urge you to be open to exploring new regulated products that suit you and help diversify your portfolio away from only mutual funds. At PrimeInvestor too, our ready to use portfolios use a mix of products to ensure your risk-return is optimal.

However, it is equally important to compare the right set of products. For example, the 10-year Bharat Bond ETF cannot be compared with banking & PSU debt funds. Although both are of high credit quality, the average maturity of both these are very different and hence the yield movements will vastly vary,. Similarly, comparing a direct Tier 1 bond offered by a bank to, say, a bond fund is also not great comparison. It is like comparing a single stock return to a portfolio of stock in mutual funds. Hence, in your search for new products, make sure your compare them right.

So, having got this far – you now know what you’re doing right when looking at mutual fund returns and where you need to change. There are other data points, apart from returns, where you may be doing a similar mix of right and wrong interpretations. That’s for another day!

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