5 Tools to evaluate mutual funds

O Learn & Keep 20 The Economic Times Wealth, September 19-25, 2011 5 TOOLS TO EVALUATE MUTUAL FUNDS These statistical tools are used by fund managers to understand the risk-reward profile of a mutual fund. Though these involve complex formulae, you don't need to calculate all of them. Simply knowing the final figures and what the ratios indicate will help you analyse the fund. TEXT: SHOBHNA CHADHA GRAPHICS ANOOP VERMA ALPHA It quantifies what the fund manager brings or takes away from the return of an invest- ment, which is based on his skill and value STANDARD DEVIATION It is a measure of a mutual fund's volatility. addition that he provides. R-SQUARED HOW TO INTERPRET IT: It measures the degree to which a fund's return fluctuates in relation to its average return over a period of time. The higher the standard deviation, the more volatile the fund, and hence, more risky as the fund's performance will rise and fall drastically in a short period of time. The ratio explains how.closely a fund's performance correlates with the perfor- mance of the overall market. HOW TO INTERPRET IT: It is a measure of performance on a risk-adjusted basis. Alpha considers the price volatili- ty of the fund and compares its risk-adjusted performance with that of the benchmark index. The excess return of the fund relative to benchmark index is called alpha. A positive alpha of 1 means that the fund has outperformed its benchmark index by 1%, and a similar negative alpha indi- cates an underperformance of 1%, HOW TO INTERPRET IT: It measures the percentage of a KEEP IN MIND: Usually, as standard deviation increases, so does the return due to the risk-return trade-off. But if two funds with same investment objectives deliver similar returns, the one with the lower deviation is a bet- ter choice as it maximises the returns for the given risk level. So, while HSBC Equity and DWS Alpha Equity aim at capital growth from diversified stocks and have performed similarly, the latter has a higher deviation. BETA It's also a measure of volatility and tells how risky a fund is in comparison to the market. fund portfolio's movement that can be explained by the movement of the benchmark index. R-squared values range from 0 to 1, where O indicates no correlation, while 1 indicates perfect correlation. KEEP IN MIND: Avoid investing in the actively managed funds that have higher expense ratios and are stilt perfect- ly correlated with the index as it will be better to invest in an index fund. In the example, ING Large Cap Equity has the same R-squared as an index fund. The 3-year returns of the fund are only 0.5% higher than the index fund, while there is a differential of 1.5 % in the expense ratio. KEEP IN MIND: Funds with negative alpha are not good options as it means the fund manager is not generating any value-added return in excess of the market. The more posi- tive an alpha, the better it is. In reality, few fund managers create a meaningful alpha that negates the expenses of the scheme. The table below shows that HDFC Top 200 has generated significant alpha, while UTI Contra has not, and JM equity has created a negative alpha. HOW TO INTERPRET IT: It measures the sensitivity of a fund's return to swings in the market. The market's beta is always 1. The index funds' beta value is equal Fund 3-year return (%) Standard deviation HSBC Equity 4.3 24.41 DWS Alpha Equity 4.25 25.44 to that of the market. If the beta is less than 1, it indi- cates less volatility than the market, and vice-versa. KEEP IN MIND: Conservative investors whose focus is Fund Expense ratio Alpha Fund Expense ratio R-squared 3-year return capital preservation should look at funds with low betas as their values are less likely to decline than those of the benchmark index in a bear phase. The table shows the performance of two funds relative to their benchmark (S&P CNX Nifty) during the bear phase-9 January 2008 to 5 March 2009. Birla Sun Life Asset Allocation Aggressive has a lower beta and fell less than the benchmark. (6) HDFC Top 200 1.78 7.88 ING Large Cap Equity 25 4.2 UTI Contra 18 0.21 2 SHARPERATIO Franklin India Index 4.7 JM Equity 25 -7.45 NSE Nifty The ratio explains whether the fund returns are due to intelligent investment decisions or the result of excessive risk taken by the fund manager. HOW TO INTERPRET IT: It is measured by subtracting the risk-free return from the fund's return and dividing the result by the standard deviation of its return. The risk-free return in India is considered either to be the bond rate or 181-day treasury bill rate. The higher the ratio, the better is the fund's risk-adjusted performance. Fund Returns (%) Beta Birta Sun Life Asset Allocation Aggressive -39.35 0.64 L&T Opportunities -63.21 1.22 S8P CNX Nifty -52.93 WHERE CAN YOU FIND KEEP IN MIND: A fund may fetch higher returns than its peers, but it's usu- ally a good option only if it doesn't take too much risk in doing so. Take Reli- ance Equity Opportunities and BNP Paribas Dividend Yield. The former mul- ticap fund has earned higher returns, but it also has a lower Sharpe ratio. THESE TOOLS? The five indicators-standard deviation, Sharpe ratio, beta, r-squared, and alpha- are easily available for free on Websites Fund 3-year return (%) Sharpe ratio BNP Paribas Dividend Yield 17.73 such as valueresearchonline.com 0.63 and morningstar.co.in. Reliance Equity Opportunities 1874 0.55 THE ECONOMIC TIMS wealth