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How do you know if you have good funds in your mutual funds portfolio: part 1

Apr 28, 2016 by Dwaipayan Bose | 139 Downloaded
Picture courtesy - PICJUMBO

If someone asks you, who is the best batsman in India today, the answer for many is quite simple, Virat Kohli. If someone asks you about the best bowler in India today, you will say Ravichandran Ashwin. To answer the question, who is the best batsman in India today, if you are statistically oriented, you will look at several key parameters, like the total runs scored, number of centuries, number of fifties, overall batting average, batting average in second innings, batting average in India, batting average overseas etc. Similarly, for mutual funds there are a number of parameters that you need to look at, to determine whether it is a good fund.

These parameters for mutual funds are trailing returns, rolling returns, quartile ranking, volatility, Sharpe Ratio, alpha etc. However, the analysis of mutual fund performance is more complex than analyzing the batting performance of a player. If a batsman has scored 20 test centuries, it is very likely that his other statistics like total runs scored, batting average etc are also quite good. There is a high degree of statistical correlation between the different performance parameters for batsmen or bowlers in cricket. Further, very good test batsmen like Virat Kohli or AB de Villiers are excellent one day batsmen too. The same does not hold true for mutual funds. A mutual fund scheme, which gave highest one year trailing returns, may not have given such great returns over the past 5 years. Furthermore, a mutual fund which delivers outstanding performance in a bull market, may not deliver great performance in a bear market. The point is that, performance of a cricketer is largely based on his or her individual abilities, whereas the performance of a mutual fund scheme is driven, to a large extent, by market conditions, at least in the short term.

Our readers often ask us, which will be the best mutual fund in the next 5 years or 10 years. Knowing what will happen in the future is impossible, but more importantly, it is not even possible to say which the best mutual fund was in the last 5 or 10 years, because it really depends on which parameter you are looking at. In Advisorkhoj, when we talk about best mutual funds, we are really talking about the best performance class, and not one particular fund which gave the highest trailing returns. We believe that trailing returns, which most mutual fund websites use to measure fund performance, have recency bias, or in other words, trailing returns are biased by the current market conditions. As an experiment, you can note down the top 5 mutual funds in a particular category, based on its current 1 year trailing returns. After 1 year, note down the top 5 mutual funds again, for the same category, based on the 1 year trailing returns. It is more likely than not that the list would have changed.

While, trailing returns are important, it is not the only significant factor in determining a fund’s performance and more importantly, long term potential. Therefore, in Advisorkhoj, we focus on whether a fund belongs to particular performance class across various time-scales and at the same time, look at various other performance parameters. In this blog post, we will discuss how to determine, if the schemes in your mutual fund portfolio are good funds or not. In this post, we will restrict ourselves only to pure equity and equity oriented funds. Please note that the process of determining good mutual funds is based on our own methodology. Other mutual funds websites and publications may have different methodologies, which may be equally valid.

To determine whether a fund is good or not, we follow a three step process. In each of these three steps, we use different analytical tools, all of which are available on our website, in the Mutual Fund Research Section. The three steps are:-

  • Look at quartile ranking of the fund, relative to its category.

  • Look at the rolling returns of the fund.

  • Look at the key risk / return performance statistics of the fund.

Mutual Fund Quartile Rankings

As discussed earlier, when we look at best mutual funds, we are really thinking in terms of performance classes. We, in Advisorkhoj, think of performance classes in terms of quartile rankings. What are quartile rankings? Each mutual fund is assigned a rank, based on its performance on some criterion for trailing annualized returns. We rank all the mutual fund schemes in each category into four quartile ranks, Top Quartile, Upper Middle Quartile Performers, Lower Middle Quartile Performers and Bottom Quartile. Quartile rankings are a measure of how well a mutual fund has performed against all other funds in its category. The rankings range from "Top Quartile" to "Bottom Quartile" for all time periods are covered in our drop down menu in the research section mentioned above. Mutual funds with the highest percent returns in the chosen time period are assigned to "Top Quartile", whereas those with the lowest returns are assigned to "Bottom Quartile". Quartile rankings are compiled by sorting the funds based on trailing returns over a period chosen by the user. Funds in the top 25% are assigned the ranking of "Top Quartile", the next 25% are assigned a ranking of "Upper Middle Quartile", the next 25% after that are assigned a ranking of "Lower Middle Quartile" and the lowest 25% are assigned the ranking of "Bottom Quartile". You can see quartile rankings of different funds in a particular category, by going to our Mutual Fund Quartile Ranking tool. Select the category that you want to see and the time period based on your own investment horizon. While, the current quartile ranking of a mutual fund scheme is important, what is even more important is the consistency of quartile ranking across several quarters, as shown in our tool. When using this tool, you should also select different time periods, to see if the funds in your mutual fund portfolio were in the top quartile or upper middle quartile, across different time periods. A fund which is consistently in the top quartile, or even the upper middle quartile, across various time periods, are in our opinion, good mutual funds schemes.


Mutual Fund Rolling Returns

Readers, who are familiar with our blog, know how much importance we give to rolling returns. Rolling return is simply one of the best measures of a mutual fund’s performance. What is Rolling Return? Rolling returns are the annualized returns of the scheme taken for a specified period (rolling returns period) on every day/week/month and taken till the last day of the duration. In Advisorkhoj, we show the annualized returns over the rolling returns period on every day from the start date and compare it with the benchmark, in our rolling returns calculator. Rolling returns is the best measure of a fund's performance. Trailing returns have a recency bias and point to point returns are specific to the period in consideration. Rolling returns, on the other hand, measures the fund's absolute and relative performance across all timescales, without bias. You can see the rolling returns of any scheme, by going to our Rolling Returns Calculator. In our calculator, you can choose the rolling returns period based on your own investment horizon. For example, if your investment horizon is three years, you should choose a rolling returns period of 3 years; on the other hand, if your investment horizon is 5 years, you should choose a rolling returns period of 5 years; so on so forth. When you select the start date of rolling returns, you are basically choosing the horizon over which you want to see the rolling returns. For example, if you choose a start date since inception of a fund, and a three year rolling returns period, the chart will show the 3 year annualized trailing returns for every day, since the launch of the fund. The rolling returns chart of any scheme has several important data points for the investor to analyze.

  • The chart shows, how many times the fund has beaten the benchmark index. It tells you about the performance of the fund manager and the consistency of his or her performance.

  • The chart shows you the gap between rolling returns and the benchmark index. A relatively constant gap tells you, whether the fund manager is employing a consistent strategy to beat the benchmark, without taking unnecessary risks.

  • The rolling returns chart tells you, the maximum loss made by the fund (over the rolling returns period chosen by the investor), the maximum returns and also a sense of the average returns of the fund, over most time periods.

  • Investors can also see rolling returns in a tabular format, instead of a graph by clicking on the button, See Rolling Returns in Tabular Format.

Rolling returns is a very important tool, and we encourage our users to use it, as much as possible, to analyze fund performance.

Conclusion (of this part)

In this part of the article we have discussed, how trailing returns are important but not the only significant factor in determining a fund’s performance for the long term potential. We have also discussed how the Mutual Fund Quartile Rankings and Mutual Fund Rolling Returns are two very important factors to analyze fund selection or its performance. In the next part of our article in this series, we will discuss Key Risk / Return Measures like standard deviation of returns, Sharpe Ratio, Beta and Alpha and how the Capital Asset Pricing Model works? Stay updated with us.

https://www.sbimf.com/SBI_Fund_Guru/assetProfiler2.aspx

Disclaimer:

Any information contained in this article is only for informational purpose and does not constitute advice or offer to sell/purchase units of the schemes of SBI Mutual Fund. Information and content developed in this article has been provided by Advisorkhoj.com and is to be read from an investment awareness and education perspective only. SBI Mutual Fund’s participation in this article is as an advertiser only and the views / content expressed herein do not constitute the opinions of SBI Mutual Fund or recommendation of any course of action to be followed by the reader

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Dwaipayan Bose

An alumnus of IIM Ahmedabad, Dwaipayan is a Finance and Consulting professional, with 13 years of management experience, mostly in MNCs like American Express and Ameriprise Financial, both in India and the US. In his last role, he was the Chief Financial Officer of American Express Global Business Services in India. His key interests are building best in class organizations, corporate governance and talent development

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