How To Compare Mutual Fund Schemes? Returns, Costs & Risks
The success or failure of every mutual fund investment revolves around three factors. Three crucial factors that decide / whether our mutual fund investment succeeds or fails. And once we understand these three factors,/ we will be in a position to select the best mutual funds from the thousands of options available out there. So in this blog, I we'll check what are those three factors / and how they affect the returns from our mutual fund investments. So let's get started
Hey, if you are new here, my name is Srijith, and on this channel, we talk all about wealth and happiness. And sometimes Mutual funds. Now I am not a financial advisor. I am just a random guy on the Internet sharing my experiences. So please do your research before you act on any of the things I say here.
This is the third blog in the mutual fund investment series. If you haven't read the first two blogs, I highly recommend that you read them to understand the basics. It will only take about 15 minutes of your time, but this knowledge can set you up for life.
Returns
Every time we invest our money, we all have one expectation. That the money will grow over time and increase our wealth. Returns, expressed as a percentage of the money invested are a way to measure this growth. It is the most important metric to evaluate a fund's performance and there are several methods to measure it.
Absolute Return
Suppose you bought a house for $500,000, fast forward a few years, and now if the house is worth 1 Million, that means your money doubled or you got a 100% return. This is called absolute return and is a common way to represent the growth of most investments, including mutual funds. Absolute return simply calculates the total growth of our initial investment in percentage terms. However, there is a problem with evaluating an investment only based on the absolute return. Because it does not consider the investment period. If we want to compare two investments, it's very important to know whether the value of that investment increased over 1 year, 10 years, or 30 years. That's where annual returns come into the picture.
Annual Returns & CAGR
Annual Returns are the growth of our investment measured in yearly terms. Simply speaking, it is the rate at which the investment should grow every year to reach its final value. In the example of the house, if the value doubled over 10 years, then the absolute return will remain at 100%. But an annual return would turn out to be 10 percent per annum for each of the 10 years. Even though this will provide us with a clearer picture of what the fund has done every year, the most practical way to understand how an investment performs is through the Compound Annual Growth Rate or CAGR.
CAGR & XIRR
This is the annual growth rate, assuming all profits from the investment are reinvested back into it. Every mutual fund includes various underlying assets like bonds and stocks, which generate income through dividends and interest. As years pass by, this income compounds and adds up to the overall return on the investment. Compounding is simply the profits earned on profits, and CAGR is the rate of return that also considers the effect of compounding over a specified period.
CAGR is a valuable metric for comparing a fund's performance with its benchmark index or with other similar funds and is mainly useful for understanding returns on lump-sum investments. However, most of us don't invest all our money at once. We mostly make periodic monthly investments at different prices or Net Asset Values (NAVs) called Systematic Investment Plans. And, for those using SIPs, a better-suited metric is the Extended Internal Rate of Return (XIRR). XIRR gives a single rate of return on investments that have multiple cash flows occurring at irregular intervals.
Now the most common method to predict if a fund will perform well in the future is to examine its historical performance. This can be measured in two ways: trailing returns and rolling returns.
Trailing Returns
Trailing returns show the performance of the fund between two specific dates. So they are also called point-to-point returns. They can be measured over various time frames, from one year, ten years, or even back to the beginning of the fund. For example, if we want to calculate the trailing returns of a scheme as of 31st December 2023, then the start date for 1 year trailing return will be 1st January 2023, the start date for a 3-year return will be 1st January 2021, the start date for 5-year return will be 1st January 2019 and so on. Although it is an important metric to understand the past performance of a fund, trailing returns have limitations. If the fund has performed exceptionally well in recent years, it could easily overshadow the performance of the past 3, 5, 7, and 10 years. Additionally, fund houses can manipulate the returns by selectively choosing the start and end dates to show favorable results, like picking a start date with the lowest NAV and an end date with the highest NAV. This can be misleading and we will not be able to get a complete picture of a fund's consistency or volatility across each point in that period. That brings us to Rolling Returns.
Rolling Returns
Rolling returns are a way to measure investment performance by looking at the returns over overlapping periods.
For example, the 1-year return for every day over the past 5 years. The returns could be calculated daily, monthly, or yearly. They help investors see how consistently an investment has performed over multiple periods.
Financial advisors often recommend rolling returns as a better indicator of a fund's performance, especially when evaluating based on historical data. However, simply looking at the returns of a mutual fund won't give us the complete picture. Two funds can show the same five-year CAGR, but the risk each fund took to get there might be very different. If two funds give the same return, we should know which fund took less risk to get there.
Risks
Every investment carries a risk. Ideally, we want to reduce the risk per unit of return, and to do that we first need to know what are the risks associated with mutual fund investments.
Company/Sector Risk
Those who have read my previous blogs would know that all mutual funds broadly come under two basic categories. Equities and Debt. When you invest in an equity mutual fund, you're essentially buying shares from several companies, either within a single sector or across different sectors. And as we know, a company's stock price is directly influenced by its performance. For example, the tourism sector struggled during the COVID crisis, causing the stock prices of related companies to drop. So, putting a lot of money into just one company or sector can be very risky. This is called an unsystematic risk, and it can be reduced by diversifying our investments across different companies or sectors.
However, the one risk we can't reduce through diversification is the risk of the market.
Market Risk
"Mutual fund investments are subject to market risk." You would have often heard such disclaimers. What does that actually mean? This is the risk that the whole market can drop because of global events like recessions, wars, or others that we don't have control over. Like the 2007-08 financial crisis. However, it's important to remember that all such market downturns are temporary and the market will eventually stabilize.
Inflation Risk
Inflation is the increase in prices of goods and services over time. If a loaf of bread costs $3 this year and rises to $4 next year then that's due to inflation. A small level of Inflation is good for the economy, but bad for our investments because this means we need to make more money from our investments to adjust for the price increase. The rate of return after adjusting for inflation is known as the real rate of return. So we have to choose funds that can grow at a faster pace than the rate of inflation.
Now when it comes to debt funds there are two important risk factors that we need to talk about.
Interest Rate Risk
And at the core of every debt-related product is a bond or some kind of loan that is tradeable on the stock exchange. They will give you regular interest payments at a set rate and return your initial investment after maturity. Interest rate risk is the risk that the value of debt security changes when market interest rates change. Means if the central bank lowers interest rates for newly issued bonds, buyers will rush to the exchange to purchase older bonds that offer higher interest. And, if the central bank raises rates, bond prices will fall as their demand decreases compared to the newly issued bonds. So the closer the maturity of the bond is to today, the lower the risk of an interest rate change; the further away the maturity, the higher the risk.
Credit Risk
Credit risk is the risk that the issuer of a bond or a loan will default on payments. It is the risk of the borrower not returning the principal and interest to the lender. This is more the case with corporate bonds and less with government bonds. To help investors understand the risk with such bonds, there are credit rating agencies whose job is to evaluate the borrowers and rate these bonds. Higher-rated bonds indicate lower risk, while lower-rated bonds have a higher risk factor.
Now that we understand the risks associated with mutual funds, we need a way to measure this risk in our portfolio. There are five parameters that can help us do this.
Standard Deviation
Standard deviation is a scientific term that is used to measure the rate of deviations from an average value. For example, if a fund's average return is 10% with a standard deviation of 2, its actual returns could range from 8% to 12%. So a standard deviation is a direct measure of market volatility. A higher standard deviation shows greater volatility and risk, while a lower one suggests more stability. Although it is good to know how volatile a fund is compared to its own average performance, we need to know how volatile or riskier is the fund compared to the market as a whole. This is where Beta comes into play.
Beta
Beta measures the sensitivity of a mutual fund to market fluctuations. And by Market, we mean the corresponding benchmark index of a fund. A Beta value of one indicates that the security’s price moves in line with the benchmark index. If the Beta value is 0.8, it suggests that the fund is less volatile than the benchmark; for example, if the benchmark index rises or falls by 100%, the mutual fund would only rise or fall by 80%. Conversely, a Beta value above 1 indicates that the fund is more volatile than the market.
Risk-averse investors should be cautious of funds with a Beta much higher than 1. However, while risk is a crucial factor, what we should be more interested in is how much returns we get after adjusting for the risk. A common metric for measuring this is the Sharpe Ratio.
Sharpe Ratio
The Sharpe Ratio is used to measure the risk-adjusted performance of an investment. It shows how much excess return you receive for each additional unit of risk you take. To find the Sharpe ratio, we subtract the expected rate of return from the risk-free rate of return and then divide the result by volatility indicated by the standard deviation. The higher the number, the better the fund.
However, the Sharpe Ratio has a key limitation: it does not differentiate between good and bad volatility. Good volatility is when a scheme gives very high returns compared to the average. The standard deviation in this case will be high, making the Sharpe ratio low. But that doesn't mean the fund is bad. Ideally, we need a way to specifically identify downside volatility, which is a major concern for us as investors. This limitation is addressed by another metric called the Sortino Ratio, which focuses only on downside risk.
Sortino Ratio
Unlike the Sharpe Ratio, which considers total volatility, the Sortino Ratio focuses only on downside volatility in its calculation. A higher Sortino Ratio indicates that a fund has lower downside risk and offers safer returns during bear markets.
Even though these ratios give a clear picture of the return after adjusting for the risk, they have their limitations. We previously discussed market risk, which is the risk associated with the overall market and not one individual security. The problem with these ratios is that they do not differentiate between general market risk and excess risk over the market. That’s where the last and most important metric, Alpha, comes into the picture.
Alpha
Funds are always compared with a benchmark index to understand their performance. Alpha is a metric that shows how much a fund has outperformed its benchmark index after adjusting for the risk. An alpha of 1.0 suggests that the fund has beaten its benchmark by 1%, while an alpha of -1.0 indicates it has underperformed by 1%. For an actively managed fund, alpha indicates the excess return that the fund manager earns compared to what he is expected to earn.
While all these metrics are useful for comparing funds within the same category, they should not be used to compare different asset classes or categories, as their risk profiles can vary significantly. For example, small-cap funds typically have a lower Sortino Ratio than large-cap funds due to their higher inherent volatility, yet both types are essential in a diversified portfolio. So always consider these metrics, in the context of your overall investment strategy. Along with risks, another factor that can affect our returns from mutual fund investments is the costs associated with them.
Costs
Whether a fund generates positive or negative returns, there will always be expenses associated with the fund. They are deducted from the investment and can affect the overall returns we receive. '
Most market-linked investment products typically have three types of costs. One, the cost to enter the scheme, also called a front load, the cost to stay in the scheme called the expense ratio and the cost to exit the scheme called the exit load
Front Load
If you invest $100 and only $98 gets invested, the $2 is known as a front load. So a crucial question to ask when buying a mutual fund is: How much of the money I invest actually go to work? Most mutual fund investments are extremely investor-friendly and have zero front load. This means there is no sales charge or commission embedded in the price of the mutual fund unit, except for minimal government taxes. However, the most critical cost that can highly influence your return from a fund is its expense ratio.
Expense Ratio
An Asset Management Company (AMC) sets up the business, rents office spaces, hires staff, and all these involve expenses. The expense ratio is a fee you pay annually to the AMC to manage your money, which covers their operating costs. For actively managed funds, the fund's performance must exceed its benchmark significantly enough to justify the expense ratio. All mutual fund returns or the NAV of a fund you see online are adjusted for these expense ratios.
The most important factor that affects the expense ratio of a fund is whether we are investing in the fund through a direct plan or a regular plan. Direct plans, where we invest directly with the fund house, have lower fees because there's no middleman commission. Regular plans involve intermediaries like banks or brokers, which adds to the overall cost. For regular equity funds, the expense ratio usually ranges from 1.8% to 2.2%, whereas for direct equity schemes, it falls between 0.5% to 1.2%.
But just because the costs are lower doesn’t mean direct plans are always the better choice for everyone. These plans require you to manage all aspects of your investment, from selecting the right funds to handling the paperwork. On the other hand, a good financial advisor, despite the added cost, can provide significant value, particularly for those new to investing.
Exit Load
Some funds also have exit loads, which are fees charged for cashing out your investment. Typically, equity funds charge a 1% exit load to discourage investors from withdrawing within the first year. While equity investments are generally intended for the long-term, it’s wise to avoid funds with very high exit loads. Because they limit our flexibility to withdraw or switch funds if they underperform.
Investing in mutual funds is a great way to achieve long-term financial goals, but it requires more than just handing over our money to a fund manager. Understanding key elements such as returns, risks, and costs is essential for making informed investment decisions that align with our financial objectives and risk tolerance.
In the upcoming blog in this series, I'll guide you on how to use all this information to select the best fund for your needs. So, make sure you visit us again and get some value from it.
Disclaimer: The Content is for informational purposes only, you should not construe any such information or other material as legal, tax, investment, financial, or other advice. It is important to do your own analysis before making any investment.
