Mutual funds combine the capital of numerous investors to purchase stocks, bonds, and short-term debt. The entire collection of these investments is called the mutual fund’s portfolio. Investors represent their proportional ownership of the fund’s holdings.
Let’s understand this way, you and your three friends pool ₹100 each to buy snacks for a party. Everyone gets snacks and drinks based on their contribution. This is similar to how investors combine their funds to create a mutual fund.
Now that you understand the basics, are you ready to simplify the complexities of mutual funds?
Let’s dive in:
1. Mutual funds ratios: The basics
Key ratios to understand
Asset under management (AUM): AUM is the total asset being controlled by a mutual fund. It includes all the assets invested by the mutual fund and the cash held by it. A rising AUM is a positive signal indicating new investments made in the fund, possibly due to positive returns generated by it.
Net asset value (NAV): It is the price at which an investor buys or sells the unit of a scheme.
NAV = Total assets managed by the fund at market value/ number of outstanding units of the fund.
Jensen’s alpha: Measures excess return of a mutual fund over the expected return, evaluated considering beta.
Sharpe ratio: Measures fluctuations of returns of the mutual fund over a period of time. This is calculated as:
Sharpe ratio = Surplus return of fund/ Risk-free rate per unit of standard deviation.
Treynor ratio: Measures the relative performance of mutual fund with the market. This is calculated as:
Treynor ratio = Surplus return of fund/Risk-free rate per unit of beta.
Fama’s measure: Measures excess return of fund considering standard deviation of market returns and standard deviation of portfolio returns instead of beta.
Expense ratio: A percentage of the investment portfolio charged annually by the fund manager. The ratio is in the range of 0.5-2 percent.
Tracking error: Return provided by the fund is not same as return provided by benchmark index. Index mutual funds have tracking errors.
2. Understanding mutual fund returns
Mutual fund returns are the profit or loss generated by your investment over time. But, do you know returns can be adjusted for risk?
How to calculate risk-adjusted returns
The formula is:
Return = (Fund Return - Risk-Free Return)/Beta.
Example: A mutual fund has 11.2% return, a risk-free return of 4%, and a beta of 3:
Risk-adjusted return = (11.2 - 4)/3 = 2.4%.
This helps you assess the fund’s performance relative to the risk taken.
3. Classification of Mutual funds
Mutual funds can be divided into different types depending on various criteria.
Fund Schemes: Open-ended funds and close-ended mutual fund schemes. Open indeed schemes are issued and can be redeemed at any time. They have good liquidity, no lock-in, and easier to invest. Close-ended schemes issue a fixed number of units. They have low liquidity and have to be listed on stock exchanges.
Management of funds: Actively managed funds and passively managed funds. The fund managers actively pick securities based on their own research and analysis under actively managed funds. While fund managers replicate an index with the same stocks and in the same proportion under passively managed funds.
Assets invested in: Debt funds invest their assets only in fixed-income instruments like corporate bonds. Equity funds invest their assets in the stock market and are highly risky. Liquid funds invest their assets in low maturity money market instruments such as treasury bills, with maturities of up to 180 days. Hybrid funds invest their money in both equity and debt funds in different ratios.
Investment objective: Growth funds are equity-based funds that primarily invest in stock markets having low dividends and high growth potential. Value funds invest in undervalued stocks with a potential for appreciation, with high dividend yield and low price-earnings ratio.
Conclusion
It is essential to understand the metrics and classification of funds before an investor picks a mutual fund. The mutual funds may sound complex initially, but careful research understanding, and diversifying your investments across different categories, can beat inflation and ensure consistent returns in the long run.