How not to judge a fund

Don’t assess a fund by its absolute returns. For a more meaningful assessment, measure a fund on a few risk-adjusted returns, all relative to its benchmark.

twitter-logo Sameer Bhardwaj        Print Edition: January 24, 2008

In today’s market, many funds promise—and even deliver—stupendous returns. Does that mean you can invest in any of them? Not really. Because although the returns of several funds might be similar, the journey to reach those returns could be very different.

Click to see funds that offer best returns

If you are a risk-averse investor, you really don't want to see your fund ride a roller coaster, even if the returns are higher than expected. Arguments can also be made in favour of investing in the oldest and largest funds.

After all, older funds have a longer history with which to judge their performance. Similarly, large funds (those with large assets under management) reflect the faith of a large number of shareholders.

You may seek the comfort of the company of a large number of investors and opt for big funds. Then there is the track record of the fund house and fund manager to go by. We analysed three types of funds—the 10 oldest, the 10 biggest in terms of assets under management and the 10 with the highest returns.

We put the 30 chosen funds through a set of statistical tests against their benchmark indices to tell you what you should be looking at in addition to returns. Some of this might sound a tad technical. Read “Behind the Numbers” to understand some of the terms used and also to know how we arrived at these results.

You don’t have to do these statistical tests yourself—just ask the person selling you funds for the additional factors we have highlighted. Once you ask for this kind of information, you are much less likely to be sold a fund you shouldn’t be.


Returns should beat the benchmark

Good funds usually outperform their benchmarks. A fund’s benchmark index broadly indicates the kind of stocks it invests in. For instance, a fund with the Nifty as a benchmark will typically buy large-cap stocks. The table “Best Returns” shows that the top 10 funds have consistently beaten the benchmark over a three-year period (see Benchmark-Adjusted Returns in the tables). For a year or two though, even a good fund may underperform its benchmark.

So don’t just look at the returns but also the benchmark-adjusted return (BAR). But a fund that beats its benchmark might have done so purely by chance. A fund loaded with tech stocks in 2007 would have underperformed its index, while one with a high exposure to banking would have
outperformed.

The beta value tells you how sensitive a fund is to movements in the benchmark. The 0.99 beta of Birla Sun Life Basic means that the fund manager has kept the fund closest to the benchmark. So a general lesson is, go for funds that have beaten their benchmarks by more than the 2.25% entry cost.


Old is not always gold

Click to see the oldest and largest funds
Age is certainly no case for veneration in the financial world. The logical reason for preferring old funds is that since they’ve been around, they know the markets and will make better stock picks. Also, there must be some reason they are still around—if they were not good, they would have shut shop.

That’s why we have also looked at the 10 oldest funds. The verdict: older is not necessarily better. Five of the 10 oldest funds (see table on following page) underperformed over a three-year term.

Those that did manage to beat the benchmark did so with small margins. The maximum extent was 6.7% by Taurus Bonanza Exclusive Growth—which is the youngest of the lot. Obviously, neither age nor returns are adequate here. That’s why it helps to study the tracking error. This shows how much a fund manager has been able to track his stated benchmark.

Both the Franklin funds in the table have the least tracking error, indicating that their fund managers follow their mandates closely. On a longer five-year annualised basis, both funds earned over 50%, indicating consistency in performance. The lesson is, a fund that sticks to its investment objective is likely to offer more consistent returns.

Size of fund doesn’t matter

Fund houses like to advertise their AUMs to give the impression that their large size also means better returns. That’s not true. Size often becomes a hindrance, preventing a fund manager from making quick investment moves. The largest diversified equity fund, HDFC Equity with a corpus of over Rs 5,000 crore, lagged its benchmark in the past one year by over 6 percentage points.

What you should also be asking for is the beta value, which measures a fund’s volatility (see bottom table). Here, Reliance Equity Fund wins, indicating predictability of returns and the fact that it is not susceptible to market swings. Five of the 10 funds in our table are from the Reliance stable—the biggest AMC in India today. UTI Mastershare is the most volatile compared to its benchmark BSE 100. So remember to look for low beta value in a falling market and high beta for low beta value in a falling market and high beta value funds in a rising market.

METHODOLOGY

Behind the numbers

To understand fund performance, this study looks at three categories of top 10 equitydiversified funds—the oldest funds, funds with highest return in the past five years and the 10 largest funds (funds with largest AUM). We have used seven parameters to evaluate funds. These are explained below. The period from December 2002 to December 2007 has been taken for analysis.

The NAVs and benchmark indices are averaged for every month and monthly returns were computed.

BENCHMARK-ADJUSTED RETURNS (BAR): This shows how a fund has performed compared to its benchmark. This is derived by subtracting the benchmark returns from the fund’s return. The fund that has outperformed its benchmark will have a positive BAR whereas a fund which has underperformed its benchmark will have negative BAR.

AVERAGE RETURN:  This is the arithmetic mean of monthly returns computed over the past years. Higher the average return, the better the fund has performed.

COEFFICIENT OF VARIATION (CV):  It measures risk per unit of expected return or in other words, how much risk one is bearing for every unit of return. A fund with higher CV is assuming more risk.

BETA AND R-SQUARE: Beta measures the volatility of a fund’s price relative to its benchmark. For instance, a fund of beta greater than 1 is more volatile than the benchmark. R-squared is a measure of the association between a fund and its benchmark and determines if the fund manager is adding value to the fund’s returns. Values are between 0 and 1, with 1 indicating a perfect correlation and 0 indicating no correlation.

TRACKING ERROR: This quantifies the extent to which a fund’s returns are at variance with the underlying benchmark over a period of time. The lower the tracking error, the better the fund because it shows that the fund manager has been able to closely mirror the benchmark index.

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