The Indian mutual fund industry has matured over the years, and the number of mutual fund schemes tailored to suit specific investment needs is almost unimaginable. This blog will look at six points investors can consider while evaluating the performance of a mutual fund.
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Define your investment objectives
Before you evaluate your fund performance on various ratios, it is essential to define your investment objectives. Figure out if you want steady income with capital protection or want to build your wealth.
For example, you can invest in a debt fund if you desire a steady income. On the other hand, equities will fit your needs if you take risks and increase your wealth.
So, once you are aware of your goals, you can evaluate your mutual fund performance, keeping your objective in mind.
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Benchmark
Every mutual fund has a benchmark. Benchmark is the yardstick to evaluate the performance of mutual funds. Before the launch of the fund, the fund house chooses a benchmark that matches the fund. E.g., the S&P BSE Small Cap Index TRI and Nifty 50 TRI can be a benchmark index for a small cap fund and a large cap fund, respectively.
The goal of an active mutual fund, or one that a fund manager actively manages, is to outperform the benchmark index. Thus, if an active mutual fund has consistently beaten the benchmark, it is considered a good sign.
This outperformance of a fund over its benchmark index is referred to as the alpha. Alpha is the ratio that shows the difference between the fund’s returns and the benchmark’s returns. A positive score means that the fund has outperformed the benchmark index and a negative score means that the fund has underperformed the benchmark.
For example, if a mutual fund has given a 15% annual return, while its benchmark has only given a 12% annual return, we can say that the fund has generated an alpha of 3.
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Performance of other funds in the same category
In addition to the benchmark, you can also evaluate mutual funds against the performance of other funds in the same category. Peer-to-peer comparison gives a better understanding of the fund’s performance. We can consider that the fund has performed better if it has consistently outperformed the other funds in the category.
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Fund manager’s track record and expertise
Your fund manager plays a vital role in managing your fund. He/she selects the stocks and makes investment decisions. To understand the expertise of the fund manager, you can check their previous performance. The past performance of the funds managed by the fund manager can be a useful metric to track their track record. However, the fund’s performance may not sustain in the future.
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Risk-adjusted returns
To provide returns, mutual funds must take risks. Typically, the higher the risk, the higher is the return.
Risk-adjusted return is another parameter to evaluate the performance of a fund. It is the risk that a fund has taken to deliver the return. If we compare two funds that have given the same returns, the fund that has taken lower risk is considered superior to the other.
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Expense ratio
The expense ratio is the total expense of the fund expressed as a percentage of the total assets of the fund. The expense ratio is subtracted from total earnings before the returns are paid to the investors. It is an essential element as a low expense ratio means a higher return and vice versa.
The market regulator SEBI has defined a range of expense ratios for equity and debt funds. Typically, active funds have a higher expense ratio than passive funds.