Investor’s dilemma – Selecting mutual fund schemes

21 june
Recently I happened to talk to one of my ex-colleague about his personal finances. At the age of about 35 years, he is well placed professionally and has been much disciplined in managing his finances. About 80% of his investments or savings were in immovable assets and in risk free investment avenues like public provident fund, National Savings Certificate, etc. Only about 20% of his investments were into equities. Equity exposure was taken through investments done in couple of mutual funds schemes. Though he was aware of benefits of investing into mutual funds, what kept him away from taking a higher exposure was the dilemma of selecting the correct mutual fund scheme. He once had a bad experience investing in mutual funds during 2010 where he did not see any major appreciations on his investments. This had in fact kept him away for about 4 years before he chose to revive his investments into mutual funds. He now chooses to do his own research based on the scheme ranking and returns as provided by various mutual fund research websites. He is however, not convinced about the approach and requested for guidance from us (K&R Planners).

Mutual fund returns is one of the most important factors which almost all investors look at before selecting the scheme. Many investors get caught in the trap of chasing performance by constantly buying the funds that are performing best and selling the ones that are performing worst. This is just another form of market timing that ensures an investor will be constantly buying high and selling low - the opposite of wise investor behaviour.

Through this article, I wish to share some insights into understanding various returns as well as some of the important investment risk indicators. These risk indicators when applied along with the historical performance, can help investors in choosing an appropriate mutual fund scheme.

Some of the different types of mutual fund returns that investors typically confront are:

1.Absolute Returns: This is the most important return from the investor’s perspective. It is the profit made over the investment tenure. For example, suppose you invested Rs 1,00,000 say about 3 years back. The value of your investment is Rs 1,40,000 as on today. Your absolute return is Rs 40,000 or 40%. Absolute return ignores the time over which the growth was achieved.

2. Compounded Annualised Return: It measures the growth in investments on a yearly basis. It is important to note that in this method, the effect of compounding is included. For example, suppose you invested Rs 1,00,000 say about 3 years back. The value of your investment is Rs 1,40,000 as on today. Your compounded annualised return is 11.9%.

3. Total Return: This is the actual return earned from the investment and includes both capital gain and dividends. Suppose you invested Rs 1,00,000 a year back. The current value of the investment is Rs 1,10,000 and you received a dividend of Rs 10,000 during the year. In this case total return will be Rs 20,000 or 20%. In other words, Rs 10,000 appreciation in investment and Rs 10,000 received as dividend will together be calculated to arrive at the total returns.

4. Trailing Returns: This is the most popular return used in the mutual fund industry. It is this return that is shown in the mutual fund factsheets and most of the research websites. This is the annualised return over the trailing period ending today or the last Net Asset Value (NAV) date. Suppose the NAV of a scheme today (November 17, 2017) is Rs 100. 3 years back (i.e. November 17, 2014), the NAV of the scheme was Rs 60. The 3 year trailing return of the fund is 18.6%. Suppose the NAV of the scheme 5 years back (i.e. November 17, 2012) was Rs 50. The 5 year trailing return of the fund is 14.9%. It is important to note that trailing returns are biased by current market conditions relative to market conditions prevailing at the start of the trailing period. Trailing returns are high in bull markets and low in bear markets.

5. Point to Point Returns: Point to point returns measures annualized returns between two points of time. For example, if you are interested in how a mutual fund scheme performed during a particular period, say 2012 to 2014, you will look at point to point returns. You will look up the NAVs of the scheme on start and end dates, and then calculate the annualized returns.

6. Annual Returns: Annual return of a mutual fund scheme is the return given by the scheme from January 1 (or the earliest business day of the year) to December 31 (last business day of the year) of any calendar year. For example, if the NAVs of a scheme on January 1 and December 31 are Rs 100 and 110 respectively, the annual return for that year will be 10%. Comparing annual returns across years relative to benchmark or fund category, can give you a sense of fund performance consistency.

7. Rolling Returns: Rolling returns are the annualized returns of the scheme taken for a specified period (rolling returns period) on every day/week/month and taken till the last day of the duration compared to the scheme benchmark or fund category. It shows the annualized returns of the scheme over the rolling returns period on every day from the start date, compared to the benchmark or category. Rolling returns measures the fund’s absolute and relative performance across all timescales, without any bias. Rolling return is also the best tool to understand, performance consistency and the fund manager’s performance.

8. SIP Returns / XIRR: All the returns discussed above relate to lump sum or one-time investments. Lump sum investment returns are relatively simpler to measure because, essentially you are measuring growth in investment value between two points of. However, systematic investment plan (SIP) represents a series of cash-flows and so computing SIP returns is more complicated. The financial metric used to calculate the returns from a series of cash-flows (e.g. SIP, SWP, STP etc) is known as the Internal Rate of Return (IRR). If cashflows are not an exact regular time intervals, then a modification of IRR, known as XIRR (in excel), is used to measure SIP returns.

Investors should avoid taking any investment decisions purely on the basis of past performance of the mutual fund scheme. Selection of an appropriate mutual scheme involves thorough analysis of various factors like risk appetite of the investor, time horizon of investment, type of funds like index funds or actively managed funds, etc.

It is important to consider the following 5 important indicators of investment risk to provide some balance to the risk-return equation.

1. Alpha: Alpha is a measure of an investment's performance on a risk-adjusted basis. It takes the volatility (price risk) of a fund portfolio and compares its risk-adjusted performance to a benchmark index. For an investor, the more positive an “Alpha” is, the better it is.

2. Beta: This risk indicator shows a mutual fund’s volatility in comparison to the market as a whole. In simple words, it is the tendency of an investment’s return to respond to market volatility. Investors with a need to protect their capital should focus on portfolios with low beta, whereas those willing to take more risks in search of higher profits should look for high beta portfolios.

3. R-Squared: It is a statistical measure that shows the percentage of a portfolio’s movement from its benchmark index movements. R-Squared Values ranges from 0 to 100. Investors should avoid an actively managed fund with high R-Squared ratio (say above 85). This is so because the performance of such fund is being very close to index funds.

4. Standard Deviation: This is applied to the annual rate of return of an investment to measure its volatility. In other words, the standard deviation tells us how much the return on a fund is deviating from the expected returns based on its historical performance.

5. Sharpe Ratio: This ratio measures risk adjusted performance and it helps investors understand whether an investment’s return is because of excessive risk factor or smart investment decision. Higher sharpe ratio indicates a better risk adjusted performance.

Selecting an appropriate mutual fund scheme from among 10000+ available scheme variants adds on to the investor’s dilemma. Selection of an appropriate mutual fund scheme with relevant fund option could prove to be a game changer in timely achievement of the investor’s goal.

We at K&R Planners help customers in addressing their challenges based on our knowledge, expertise, trust and transparency.

Disclaimer: This article is for investor education purposes only and should not be construed as promotion / solicitation of any financial product.

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