Mutual Funds Scheme Evaluation

Performance Measures and Ratios

A fund’s performance is measured in terms of

1. Absolute Return
2. Relative Return

Absolute return is measured with respect to a period be it a week, month, year or so on whereas relative return is measured with respect to benchmark and competitors fund return of the same category.

It is best to measure a fund’s performance in long term as usually in takes 5 years to complete an economic cycle and within that period how much compounding return has the fund manager generated on his fund is a better measure of his skill sets.

Once a list on mutual fund scheme within a category is sorted based on absolute and relative performance of fund managers, we perform risk adjusted performance measures to select mutual fund schemes.

If two otherwise similar potential investments offer the same return but differing level of risk, we would prefer the one with the lower risk. There are a number of metricise that allow us to measure return relative to risk for purpose of evaluating and ranking investment options.

Fixed Income Fund Performance Measures

Fixed income securities have a predefined interest rate or coupon that is paid on specified dates and a fixed maturity date. However there is an inverse relationship between market interest rate and bond value. As interest rate rises, the value of bond falls and vice-versa. It is useful to assess the level of sensitivity of a bond to the change in level of interest rate. There are few bond matrices that measures the sensitivity of interest rate change to value of bonds.

Duration

The longer the time to maturity for the bond, the more sensitive it would be to changes in interest rates. The maturity measures only the time until the principal is due and does not consider the interest payment.

Duration is a measure that incorporates both the magnitude of interest change and principal payments and the timing of those payments. It is considered as the weighted average time to receipt of both interest and principal payment where weights are present value of each cash flow.

In the above example we have assumed a bond price of Rs. 1000 paying 7.5% interest semi-annually for 3 year and calculated the duration of 2.71 years which is 3 years. An interest paying bond will always have its duration less than its time to maturity.

Modified duration calculates the rate of change price of bond value with given change in the interest rate.

The modified duration calculated for the above example,

Modified Duration = 2.71/ (1+7.50%/2) = 2.61

This shows that with every 1% movement in interest rate, the price in bond is to change by 2.61%.

Let’s take an example of 2 different duration fixed income mutual fund schemes:

If it is expected that RBI is likely to raise interest rate by 50 basis points, then according to modified duration calculation the short-term bond fund is likely to fall by 1.3% in value whereas long-term bond fund will fall by about 3.2%.

Equity Fund Performance Measures

Sharpe Ratio

It’s a measure that indicate the amount of return earned per unit of risk. The appropriate way to rank the risk-adjusted performance of various portfolios is by calculating their excess return per unit of risk.

Portfolios with higher Sharpe ratios provides superior excess return per unit of risk over the period measured compared with portfolios with lower Sharpe ratios. 

Treynor Ratio

It measures excess returns per unit of systematic risk whereas Sharpe measure excess return over total risk.

Beta is a measure of variability of return on an asset or portfolio relative to the variability of return on the market.

Jensen Ratio

It is measured in terms of alpha. Alpha measures the contribution of fund manager in terms of percentage. It measures the incremental rate of return per period measured in excess of the return attributable to the risk the portfolio has assumed.

Sortino Ratio

This measures the risk that include both downside variability and upside variability. Investors are most concerned with downside variability.

In this ratio, target rate of return is the minimal acceptable return that could be set at some absolute value by the investor, such as zero, the risk-free rate, or some target return. The downside deviation measured similarly to standard deviation but using only return below the target rate of return in the computation.

Equity Mutual Fund Universe

For illustration purpose we will take multi-cap equity mutual fund schemes and run performance measure for scheme selection. Under multi-cap funds category there are 48 schemes till date where the average 5 year compounding return of multi-cap fund category has been 18.14% where the maximum return has been 26.21% CAGR and lowest fund performing 7.76% CAGR.

To filter schemes for selection, we only select schemes that have been performing better than the average (18.14%) which cut down our selection to just 23 schemes passing our criteria. 

The ones that have been marked in blue are fund schemes within the multi-cap fund category where the fund managers have performed better than its peers on a risk adjusted basis.

Once our selection based on performance ratio is run and we get a set of fund schemes then we need to perform portfolio attribution to narrow down to our final selection.

Portfolio performance attribution is an analysis technique performed to identify as to why a portfolio’s performance differed from its benchmark. The difference between the portfolio return and the benchmark return is known as active return and this active return is generated by managing the portfolio actively.

Attribution analysis attempts to distinguish between two factors that have lead the fund manager’s outperformance:

1. Superior Stock Selection
2. Superior Market Timing

This method compares the total return of the manager’s actual fund holdings with the return for a predetermined benchmark portfolio and decomposes the difference into a selection effect and sector allocation effect.

As mutual fund investors we are more concerned with investing with fund managers who have high capabilities for stock selection and rather than market timing.