In this multi-part series we have discussed how to select the best mutual fund schemes. In our previous part, Do you know the most important parameters in selecting mutual funds, we discussed 4 simple factors to consider, when selecting mutual funds for investments. However, we know that, some of our readers are more analytically oriented and quantitative information helps these investors to make investment decisions more efficiently. For the benefit of investors with more advanced knowledge investing and finance, we will discuss the most important analytical measures that you can use in selecting the right mutual fund schemes.
I have read many blogs which have discussed the 10 or 14 most important parameters for selecting mutual funds. While these blogs are interesting for academic purposes, I find their utility limited because of several reasons. Firstly, an average retail investor has a day job and limited time to commit towards managing investments. Looking for information on 10 parameters and more importantly, understanding the data, takes time and effort. Secondly, looking at a lot of different parameters may give you confusing signals. Thirdly, all the parameters may not be useful for all investors – some parameters may be useful for specific investment needs.
In Advisorkhoj, our objective is to simplify mutual fund investments for the retail investors. In our MF Research Section, we have information on almost all mutual fund performance and risk measures. However, not all parameters will be always relevant for you. In this post, we have for you only the two important analytical measures for selecting equity funds and another two analytical measures for selecting debt funds. You will save a lot of time and effort, at the same time, your fund selection can be quite effective. However, before you use these measures, we urge you read our post, Do you know the most important parameters in selecting mutual funds, because the points mentioned in that post are also important.
Two most important analytical measures for selecting equity funds
As mentioned previously in this series, a lot of information on returns is available on different research websites, but returns can be misleading depending on market conditions – for an equity fund 10% return can be a fantastic performance in one year and poor performance in another year. Some of the other risk and performance measures like standard deviation, Sharpe Ratio, Sortino Ratio, R-Squared, Capture Ratios, Drawdown etc. can be difficult to understand / interpret. We will keep it simple with just two measures – Alpha and Beta. These are two most effective measures of a fund manager’s strategy and performance. Though alphabetically, alpha precedes beta, for understanding purposes, let us talk about beta first.
Beta: Beta is a metric which helps us understand the risk taken by a stock or fund relative to the relevant market benchmark (the scheme’s market benchmark is mentioned in the factsheet and scheme information document; you will also find this information in our MF Research Section and other research websites). Before you look at beta of a fund, it is very important that you know the scheme riskometer profile (because different market segments have different risk profiles). Within a particular riskometer profile, the risk characteristics of different schemes can be different, based on the fund manager’s strategy. This is where beta is important.
Beta of a fund is defined as the excess returns of the fund over the risk free rate relative to the excess returns of the benchmark index over the risk free rate. Let us understand this with the help of an example. Let us assume you can get 7% interest from your fixed deposit. This is the risk free rate because you do not take any risk when investing in Fixed Deposits (please note that this risk free rate assumption is purely illustrative – usually schemes use interbank rates for risk free rates). Let us further assume that you have invested in a fund whose benchmark index is BSE-100 and the beta is 2. If BSE-100 rises by 15%, how much return can you expect from your fund? The answer lies in a theory called Capital Asset Pricing Model, in finance parlance, popularly known as CAPM (pronounced as Cap-M). As per CAPM:-
In the above example:-
Expected Return of the Fund = 7% + 2 X (15% - 7%) = 23%
What if BSE-100 falls by 10%? As per CAPM:-
Expected Return of the Fund = 7% + 2 X (-10% - 7%) = -27%
We can see that, beta is a double edged sword. Higher the beta, higher is the potential returns in bull market, but we also risk higher losses during bear markets. A fund with beta of less than 1 is considered a low beta fund; funds whose beta is much more than 1 are high beta funds. It is important to understand that, a high beta fund is not necessarily a bad fund and vice versa. You should select funds with higher or lower beta based on your risk appetite. If you have an aggressive goal and high risk appetite, you can select high beta funds; on the other hand if you are less aggressive and want more stability in your portfolio you should select a low beta fund.
Alpha: In my opinion, this is the single most important performance parameter of a mutual fund scheme. Alpha is the excess returns generated by the fund manager, compared to what he or she would have expected to get after factoring in the risk taken by him or her. In mathematical terms:-
Compare this formula with the formula in the box shaded light blue. You will realize that alpha is the value added by the fund manager, for the same amount of risk. Let us understand this concept by revisiting the example discussed earlier. Let us assume you can get 7% interest from your fixed deposit, which we say is the risk free rate. Let us further assume that you have invested in a fund whose benchmark index is BSE-100 and beta is 2. If BSE-100 rises by 15%, how much return can you expect from your fund?
As per Capital Asset Pricing Model (discussed earlier) you can expect a return of 23% from your fund. Let us assume you get a return of 25%. How did you get 2% extra returns? It was a result of the value created by your fund manager. The 2% is the alpha of the fund. What if BSE-100 falls by 10%? As per CAPM your expected return would be -27%, but if your fund manager is able to generate a 2% alpha, your actual return would be -25%.
From a conceptual standpoint, alpha is the excess return generated by your fund manager versus what is predicted by CAPM. The top performing funds that have sustained their outperformance over a sufficiently long period of time are undoubtedly funds with high alphas. If a fund manager has generated high alpha, it is quite likely that he or she will generate high alpha in the future as well. High alpha speaks to the fund manager’s ability of stock selection and portfolio construction. When selecting equity funds for your mutual fund portfolio, you should always select funds with high alphas.
Two most important analytical measures for selecting debt funds
Awareness about debt mutual funds is low in our country. Based on my observations, even many experienced mutual fund investors avoid debt funds because they find it too complicated. I can empathize with investors who find debt funds complex because the array of debt funds categories is bewildering and many investors may find debt fund investment strategies to be too quantitative. However, debt funds are wonderful investment options for a range of investment needs, risk appetites and tenures compared to traditional fixed income schemes. As an investor you need to cut through all the clutter and know what is most important.
Debt fund investments are usually made for much shorter tenures compared to equity funds and for longer tenure investments in debt funds, income is the most important consideration. Therefore, in my view, risk is the most important consideration in debt fund investments. The two major risks in debt funds are interest rate risk and credit risk. If you are able to select the right schemes based on these two risk factors, then debt funds can help you meet your specific investment needs. Accordingly, in our view, the two most important analytical measures for selecting funds are modified duration and credit quality.
Modified Duration: Bond prices rise when interest rate falls and vice versa. Some bonds and debt funds (which invests in bonds) are more sensitive to interest rate changes compared to others – they rise faster when interest falls and fall faster when interest rate rises. The interest rate sensitivity of a bond or debt fund is known as the modified duration. Modified duration is simply the price sensitivity of a bond to changes in yields or interest rates. So if the modified duration of a bond is 10 years and interest rates go down by 1%, then the bond price will increase by 10%.
Some readers to wonder, why is price sensitivity of a bond called Modified Duration? In the literal sense, duration should be related to the tenure (maturity) of the bond? Even from a technical standpoint, modified duration is closely related to the bond maturity profile of the debt fund. A detailed technical discussion on modified duration is outside the scope of this article, but if you are interested in knowing more about what modified duration is, please read our blog post, Do you know how to select Debt Funds: Modified Duration and Volatility.
Risk and returns are directly related. If you want to get more returns by taking more risk, select a fund with high modified duration, but if you want stability then select a fund with moderate to low modified duration – modified duration of less than 2 years. Higher modified duration debt funds will give you significantly higher returns than traditional fixed income schemes like FDs, Government Small Savings Schemes etc. in favorable (declining) interest rate scenarios. Even moderate modified duration debt funds (modified duration of 1 – 2 years) can give better returns than traditional schemes in stable interest rate scenarios. Schemes whose modified durations are less than 1 year fall in the money market category – these are very low risk schemes and the returns are also lower.
Credit Quality: Let us now come to credit risk. Higher the credit quality profile of a fund, lower is the risk of price (NAV) decline due to credit rating downgrade or default. The risk of an AA rated bond defaulting is much less than a BB rated bond. Therefore, if you want to reduce the credit risk of your investment select a debt fund which has a high proportion of AA or higher rated bonds in its portfolio. Let us understand how credit rating scale works. The table below describes the credit rating scale used by CRISIL to rate debt securities.
You can find the credit risk profile of a debt fund in its factsheet; some mutual fund research websites also has this information. You should select funds based on credit quality, as per your risk appetite. If you have low risk appetite, select funds which have 80% or more of their bond / NCD portfolio in AA or higher rated securities. However, you should note that, lower rated bonds give higher yields. Not all lower rated bonds get downgraded; only a few ones facing serious financial troubles are downgraded.
If you want to capture an extra few percentages of yield you can invest in credit opportunities funds, which have a higher proportion in lower rated papers, but as always, you should be cognizant of the risks. We must caution investors that, sometimes even a relatively highly rated debt paper (bond) can suddenly be downgraded. This will impact the returns of funds holding a high percentage of such papers in their portfolios. There have been a few instances like these in the past two years or so.You should be mindful of the risk of an unexpected rating downgrade.
Our endeavor in Advisorkhoj is to empower investors with knowledge to take the best financial decisions, as per their needs. The mutual fund industry and financial advisor community is doing a commendable job in increasing financial awareness. Retail investors today have more information resources than what we had 12 or 15 years back – this is a very positive development, but at the same time, investors should know what is relevant for them and what is not. In this 4 part series, we discussed what to analyze and ignore when selecting equity mutual funds. Hopefully, this series helped you increase your knowledge about mutual funds, clarify doubts and focus on the really important factors in mutual fund investments. As always, if you are in any about, please consult with your financial advisor or feel free to reach out to us.
Mutual Fund Investments are subject to market risk, read all scheme related documents carefully.