10 tools for analyzing Mutual Fund
I hope you all are aware about Mutual Funds. But before starting let’s have a quick recap. Mutual Fund is a common pool of money raised from potential investors and that is invested in various stocks or debt instruments based on certain investment strategies. Each investor owns part of the fund based on their respective contributions. This is a very popular and effective method of investment for the newbies because normally mutual funds are managed by qualified professionals. So you do not have to research on the stock /debt instruments for investment. You get all of these against a small fund fee
But choosing the right type of mutual fund depending on your financial risk appetite (check your financial risk appetite here) is very important. Here in this article, I’ll discuss about 10 tools which will guide you to select the right mutual fund for your portfolio.
This ratio is the industry standard measure to calculate the risk adjusted return. The Sharpe ratio is the average return earned in excess of the risk-free rate per unit of volatility or total risk.
It is calculated by the following formula:
Sharpe ratio = (Mean portfolio return − Risk-free rate)/Standard deviation of portfolio return
Being an investor, you need to compare the Sharpe ratios of the funds belong to same category.
If any fund have higher Sharpe ratio than the average one then it indicates that the fund manager of the fund was able to generate higher return under same risk profile.
Tip: Higher the Sharpe Ratio, better the fund
It is the ratio of fund’s operating expenses and average value of its assets under management (AUM). This is the amount charged to the investor by the Fund house as fees. It ranges between 0.1% (for fixed maturity plans) to 3.25% (for small-sized equity funds).
TIP: Lower the expense ratio, better the return from the Fund.
3.Portfolio Concentration Ratio:
This ratio shows where the fund has invested its money. It shows the amount of the top 5 stocks or sectors of the fund in percentage basis.
Carefully watch the diversification of the fund because undue concentration may hamper its goals. Normal range for top 5 stocks are 30%-40% and 30%-60% for top five sectors in the diversified funds.
Exit Load: This is a fee or amount charged by the Mutual Fund House to an investor for exiting or leaving the scheme of the company. Typically after a certain holding period, say One year, Exit load is not charged.
This exit load is deducted from the NAV at the time of redemption of the fund as per the given percentage. Normally the percentage of exit load varies in between 0% (for liquid funds) to 1%. The funds with no exit load or a charge is known as No-Load Funds.
TIP: Lower the Exit Load, better the return from the Fund.
Standard Deviation (SD) of a fund calculates the volatility or risk of a fund’s return compared to its average return. It tells you how much the fund’s return can deviate from its historical average return. Suppose if a fund has an average return of 10% with a standard deviation of 3% then its return will be within the range of 7-13%.
Of-course, the funds with lower standard deviation is always preferable. But compare the standard deviation of the funds within a certain category because normally SD is lower in case of liquid fund compared to equity funds.
Tip: Lower the standard deviation, better the fund
6.Portfolio Turnover Ratio:
This ratio shows that how frequently assets within a fund are bought and sold by the managers. This turnover ratio is high for the actively managed fund and low for the passively managed funds.
Portfolio turnover is calculated by taking either the total amount of new securities purchased or the amount of securities sold, whichever is less over a particular period, divided by the total net asset value (NAV) of the fund.
If a fund’s total asset value is $10 million and the fund bought $15 million and sold $10 million securities in that year then portfolio turnover ratio is 100%.
A fund with 30-50% turnover ratio indicates it follows buy and hold strategy and passively managed fund. While a fund with portfolio turnover ratio of 100% or more indicates that it is a actively managed fund.
It depend on your investment strategy what type of ratio is good for you. If your financial risk taking ability does not allow you for very actively managed fund then go for lower turnover ratio fund. But keep one thing in mind that the yearly average transaction cost will be higher in case of the funds with higher turnover ratio.
It indicates the fund’s performance compared to the market. By definition, the market assumed to have a beta of 1.0 and the beta of other individual securities and funds are measured according to how they deviate from the market.
Suppose, a fund has beta of 1.2 then it indicates it’s theoretically 20% more volatile than the market.
If you are a conservative investor then look for the funds having low betas and if you are among them who want to take more risk for having more returns then look for the funds having higher betas.
This ratio is popularly known as reward-to-volatility ratio as it indicates the return per unit market risk or systematic risk.
It is calculated with the following formula:-
(Portfolio’s return-Risk free rate)/ portfolio’s beta
A higher Treynor’s ratio indicates the fund manager’s ability to generate higher return in every unit of market risk compared to the other funds in the same category. Yes, always compare the ratio within the same category.
Tip: Higher the Treynor’s ratio, better the fund
All the above tools are applicable to any type of funds. But there are two more tools which are only applicable for the funds having debt securities.
All debt papers that the fund invests in are rated by certified credit rating agencies according to their risk profile. Normally corporate papers are rated from AAA (highest safety) to D (default).
Every agency has its own method to rate the debt papers and these ratings are generally provided in the Fund’s fact sheet.
Tip:Always look out for the funds having higher rating as it indicates lower risk.
10.Average Maturity or Maturity Profile:
Debt funds invest in different debt papers with different maturity period. Average maturity or maturity profile of a fund indicates that average maturity of all debt papers in a fund. Investors can get this information from the Fact sheet of the Fund.
Normally the prices of debt papers with long maturity are more sensitive to interest rates compared to the debt papers with shorter maturity. So, if there is a chance in the market of falling the interest rates then go for debt funds with higher average maturity as it likely to give higher returns and vice versa.