How to Evaluate the Performance of a Mutual Fund?

Mutual funds are a popular investment choice among regular investors today. Several mutual fund plans are offered in various categories. Choosing the correct fund might be challenging. You must conduct the performance evaluation of mutual funds. This will help you determine what is appropriate for your investing objectives. 

Why track the investment performance?

You may have encountered the disclaimer stating that past performance does not necessarily predict the future performance of a fund. This implies that investment returns are not guaranteed, necessitating a thorough evaluation beyond historical returns when assessing a mutual fund.

Primarily, it’s essential to regularly monitor your investments to make informed decisions that could potentially lead to higher returns. Recognising that the capital market is subject to fluctuations due to changes in overall economic conditions, it’s crucial to stay vigilant. Such fluctuations can disrupt the asset allocation of your portfolio; for example, an initial 50:50 allocation in equity and debt may shift to 60:40 during a market rally, increasing the fund’s risk profile beyond your desired level.

Performance evaluation of mutual funds also allows for a comparison of its performance against similar funds. Moreover, changes such as a new fund manager or alterations in the fundamental attributes of the fund may necessitate a review. Consequently, periodic review and rebalancing may be necessary to maintain the risk profile of the portfolio at an acceptable level.

Here are some crucial parameters you must analyse for performance evaluation of mutual funds.

Returns 

The most basic starting point is to look at the fund’s historical returns across different time periods. These time lengths could range from one, three and five years etc. This will give you an idea of the fund’s short and long term performance. Ensure you compare the returns to the category average as well as benchmark indices to gauge whether the fund has lived up to its peers and market.

The annualised returns also help assess the fund’s compounding effect over long tenures. Avoid focusing only on short-term performance and check consistency in long-term returns.

Risk-adjusted returns 

Along with absolute returns, it is vital to analyse return ratios like the Sharpe Ratio. These ratios adjust the returns in relation to the risk taken to generate them. A higher risk-adjusted return means the fund has delivered superior returns per unit of risk taken. The fund with the higher Sharpe ratio would be a better choice in similar fund categories.

Benchmark

It is usually good to compare the fund’s performance to the benchmark. The benchmark serves as an indicator of fund performance. If your fund continually outperforms the benchmark, it indicates that it is doing well. You can also compare the average return over a specified time period to peer funds in the same category.

Volatility & consistency 

The annualised standard deviation measures the volatility and consistency in returns over a period. A lower standard deviation indicates more stable and consistent returns. Again, compare the fund’s standard deviation to its peer category to ascertain if the fund has demonstrated lower volatility. Also, check rolling returns over calendar years to assess return consistency.

Downside Protection 

Evaluate how the fund has fared in bear markets or periods of negative market returns. Analyse the downside deviation, which measures the fund’s volatility only for periods when the market saw negative returns. Lower downside deviation denotes better capital preservation. The maximum drawdown indicates the maximum loss faced by the fund from its historical peak value. A smaller maximum drawdown represents better downside protection.

Portfolio Composition

Review the mutual fund’s portfolio characteristics like the top holdings, sectoral allocation, market cap wise break-up etc. Check if the portfolio construct is aligned with the fund’s mandate and category. Assess the diversification across stocks and sectors to gauge the fund’s exposure to concentration risk.

Fund manager’s expertise

Your fund manager is an essential character in the portfolio, making investment and stock selection decisions. Recognise your fund manager’s competency based on their fund management knowledge and skills. Your fund manager’s previous performance would be a good statistic to use to assess their track record, and it might benefit your investments significantly.

Fund’s fee structure

You compensate a mutual fund business for its services and expertise. Some funds need careful management and timely choices on buying, selling, or keeping an asset. Keep in mind that a fund with a higher fee is always preferred. Before making a decision, consider all possibilities.

Portfolio quality

The ability of stocks in the portfolio to produce greater returns on investment for a set period of time demonstrates their quality. Consider the mutual fund’s industry leadership position. The returns, and hence performance, will reflect the quality of the portfolio’s shares. Qualitative data and mutual fund performance history would help to measure performance.

Expenses 

A fund with a high expense ratio eats into a significant share of returns. Compare the fund’s annual recurring expenses relative to its category peers. Opting for the direct plan and growth option further helps save costs.

Evaluating these quantitative metrics along with qualitative aspects like the fund manager’s experience, investment philosophy and processes can help identify winning funds aligned to your investment objectives and risk appetite. Tracking mutual funds over long periods accounting for different market phases is crucial for informed decisions.

How often should you evaluate your fund’s performance?

Now you know how to evaluate the performance of a mutual fund. The stock market is susceptible to fluctuations, but this doesn’t mean you need to assess your fund’s performance daily. Depending on your investment horizon, reviewing your fund every six months to a year is advisable. A shorter evaluation period may not offer an accurate depiction of your asset’s success.

Managing these tasks seems overwhelming and you might consider investing in conventional funds. Certified intermediaries typically recommend funds based on your financial goals and risk tolerance.

Some of the changes include:

1. Change in fund manager

In the event of a change in the fund manager, it’s advisable to familiarise yourself with the new manager. You must discuss the potential implications for the fund with your advisor. Each fund manager has a unique approach to managing money, which could influence the fund’s performance.

1. Fund closure

There might be instances when a fund closes for various reasons and returns investors their funds. In such cases, the mutual fund will provide advance notification, requiring you to adjust your portfolio potentially.

2. Scheme merger

Consider a scenario where, subsequent to investing in Scheme A, a large-cap equities fund, the mutual fund company merges it with Scheme B, a multi-cap fund. Consequently, you would need to withdraw your investment from the original large-cap fund and reallocate it to a different one.

The bottom line

It is essential to assess performance evaluation of mutual funds in India in order to make informed investing choices. Examining the aforementioned aspects in detail might provide you with insightful knowledge about your assets. Make the most of this knowledge by using it to guide your decision making. It will optimise your financial objectives and risk tolerance.

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