Choosing a debt fund • Debt funds are generally considered to be less risky and simpler to understand than equity funds • Corporate and institutions invest more in debt funds than individuals • Several investors use debt funds to generate regular income • If used well, debt funds can be more tax efficient than FDs • Debt funds are of three types:     Income or bond funds     • These invest in corporate bonds, debentures     & FDs     • Maximum retail investor money comes in         this category Liquid or money market funds     • These invest in treasury bills, call money,         commercial papers     • Institutional investors dominate this                 segment     Gilt Schemes     • Invest in government securities only     • Least popular of the three categories, with     barely any retail investment • Returns on debt funds are inversely related to interest rate movements

Click here to see 'Returns: Choosing the right period'

Click here to see the chart: Macro economy and your fund investments

Have you seen this formula before?  (Average Return of the Portfolio - Average Return of the Risk-Free Rate) /Beta of the Portfolio.

Stumped? You have every reason to be. These are statistical tools used by managers of mutual funds to calculate, among other things, returns in different market conditions. No, we are not about to tell you to whip out your scientific calculator and perform minor miracles. What we are saying is that if you want to be an intelligent investor, it pays to know what your fund manager is doing and why he’s doing it. It also pays to know what’s happening in the market, even if you don’t invest directly in equities. Most of us assume that if a fund delivers high returns over a year or so, it’s worth investing in.

Unfortunately, what most of us fail to understand is that high returns invariably come with high risk. If you invest in a high-risk option when you have a low risk appetite, you are only paving the way for future unhappiness. Knowing what to look for in a mutual fund is half the battle won. Knowing how to use that information profitably is total victory.

If you have a clear financial goal, your risk appetite and investment tenure will more or less fall into place. Dozens of mutual fund studies confirm that past returns have almost no predictive value. These days, every fund prospectus carries a table showing how the fund did in its worst quarter or year. Ask yourself whether you can withstand that level of loss. If the answer is no, look at another fund.

And you have plenty of choice. The mutual fund industry is still in a nascent stage in the country, and new schemes are being launched almost by the day. Given the bewildering array of funds and schemes to choose from, it’s imperative that you understand what suits you best and what will meet your financial goals.

Investment horizon: If someone tries to sell you a fund scheme based on its three-month or oneyear returns alone, be very wary. The long-term performance, three or five years, is the best indication of the fund sticking to its investment objective. It goes without saying that if a fund constantly lags behind its peers, there is something wrong in its investment strategy.

However, if you’re already in a poorly performing fund, pay attention to the investment approach of the fund before making the decision to exit; a conservative investment approach may mean lagging behind peers in times of boom. However, when the market falls, the conservative fund may score over others. How long are you prepared to stay invested in a fund and what do you expect the returns to be over that period? This is an important question, as the answer to it determines the kind of fund you invest in.

For instance, equity funds are not advisable for the short term, while money market and floating rate funds offer short-term gains. Do returns matter? We’ve said it before and will be saying it over the next several years: returns are not the only way to measure the performance of a fund. Having said that, it’s still important to understand the returns and know what to make of the fund’s performance over different time periods.

Most funds publish their performance for one month, three months, six months, one year, three years and since inception. The performance will be given in simple percentage points. If you want something more refined, visit various websites that offer daily fund analysis. When looking at the fund’s returns, never forget that these numbers are generally pegged to a benchmark.

For instance, a diversified equity fund should be on par or above the broad index such as the BSE 100 or the Nifty. Similarly, you should check out the relevant index if you are investing in sectors. For instance, check the IT index if you have investments in a technology fund or the health-care index if you are an investor in a pharma sector fund.

However, there are limitations assessing funds against benchmarks. The fact that benchmarks are weighted is a limiting factor. Many funds adopt a benchmark for lack of choice, which means the investment objective is not clearly reflected in the benchmark chosen. This is somewhat similar to picking rotten oranges; they look just like the good ones from the outside, but are really no good when peeled. Fund mandate: There’s a limited universe of benchmarks, and many funds are pegged to the same index. What differentiates one from another is the investment philosophy.

For instance, an equity-tax saving fund and an equity-diversified fund have the same benchmark, but the tax fund manager has an edge, as redemptions and withdrawals are not as high as they are in diversified equity funds.

All of which brings us to the allimportant question: what is the best way to analyse a fund? There is no right way or wrong way to assess and analyse a fund as a lot depends on individual risk and comfort. To understand the core characteristics of a fund, however, there are several statistical tools that can be used. These are the same tools that fund managers and MF analysts use, so you can be sure that the results have been tested over time.

However, that does not mean that you have to learn to use these tools. We have used the Sharpe, Jensen, Treynor and Sortino ratios on selected funds to measure returns in relation to risk, volatility and benchmark performance.

But before you learn how fund managers calculate returns, it’s a good idea to understand what they mean when they use the word. Reports often use the terms annual return, average annual return, annualised return, and compounded rate of return interchangeably. But each of these is different from the next.

After all, if they all meant the same thing, then a single term will suffice, won’t it? The three most common forms are total return, annual return and annualised return. Total return means just that—the percentage gain or loss of your fund over its purchase price, irrespective of the buy date and the date you wish to check the returns or sell it.

The annual return refers to a fund’s percentage NAV change over a year, factoring in dividends, capital gains (if any) and reinvestment of dividends. The annualised return (also referred to as the compounded annual growth rate or CAGR) is the average annual return that the fund makes (or loses) each year in a multi-year period. Most funds show average annual returns for one-, three- and five-year periods.

That was relatively simple, wasn’t it? But analysing and calculating those returns across different parameters is altogether another kettle of fish. That’s where the Greek comes in—and that’s where it pays to be a statistician. It also pays to understand how the markets function and the different economic and political events that can affect market movements.

That’s easy enough to do, given the profusion of pink papers in the country. As for the statistical analysis, you don’t really need to know the details. What’s important is that you know that these tools exist and that they provide a useful service. We have shown you in the following pages a sample of how these tools work; we are not recommending that you go out and immediately buy these funds, because that will be a function of your financial goals and investment horizon.

 

March with the markets

Until recently not many experts saw anything wrong in index funds, those “passive” portfolios that buy all the stocks that constitute an index and keep them forever. With the kind of beating the indices have taken in recent months, index funds are being written off by the very same experts. “The 21 index funds are concentrated around the Sensex and Nifty. Except for fund house diversification, an investor does not get any index diversification,” says Prasunjit Mukherjee, CEO, Plexus Management. (Click here to see graphic: Hare and Tortoise)

The performance over the past four months is abysmal. Index funds have lost between 11% and 63%. So, are index fund managers getting it wrong? When stock markets are crashing, doesn’t it make sense to switch from index funds to actively managed funds? After all, a smart stock picker should be able to dodge the next crash and still pick winners in Bharti Airtel, DLF and the IT sector. Actively managed funds tend to outperform index funds. The returns from the Franklin Sensex Fund and the Kotak Opportunities Fund moved in tandem between September 2006 and September 2007. But after that, returns from the diversified fund shot up dramatically and have since stayed ahead (see chart).

Still, there are several points in favour of index funds. For one, you get to invest in all the top Indian companies that are in an index, spreading the allocation among stocks in the same ratio as the weightage in the index.

But perhaps the biggest case for index funds is that their costs are lower than those of actively managed funds. There is another variant of index funds—exchange traded funds or ETFs which are even more cost effective. Investors can buy and sell these ETFs just like they trade stocks on exchanges. The minimum investment is the price of one unit and the entry load is the 0.3-0.5% brokerage paid to the broker.

• Choice of 21 index funds and 12 ETFs
• NAV of an ETF is a fraction of the value of its benchmark index
• ETFs resemble a closed-ended scheme, where units are not sold back to the fund
• ETF investors buy and sell the fund units on the market
• Minimum ETF investment is price of one unit. Entry load is the brokerage