In the previous chapter, we learnt about risk – how important it is to define risk appetite before planning ahead. We saw the benefits it offers us and learned about various risk profiles based on which a suitable mutual fund can be picked. The next step is to evaluate the fund based on its performance. This is exactly what we will focus on in this chapter. We shall look into how we can analyse a fund’s performance in order to make a decision whether to invest in the same or not.
Before we begin, let us imagine a scenario. Suppose 10 years down the line, Ranjit (Yes, that robotics guy) earns enough money to buy a vacation house in Goa. How do you think he will proceed with that? Will he just buy any house that he comes across since he has enough funds to buy? Absolutely, NO!
He will perhaps hire a broker and go through multiple options. After shortlisting a few options, he might consider visiting them all personally, assess the neighbourhood, check water and other facilities, house papers, and whether everything else about the property is in order. He might even go one step ahead and chit-chat with neighbours to find out if the property is worth the investment.
Similarly, before you invest in a mutual fund, you need to go through different options to pick those according to your requirements. Remember, just like all houses are not suitable for Ranjit’s vacationing purpose, all mutual funds are not suitable for all kinds of financial goals.
The best way to do this is by evaluating the performance of various funds that meet your financial goals and risk appetite. Out of different components that help you in analysing a mutual fund, a comprehensive study about its performance gives you an idea about how well the fund is doing. We all want to pick the best performing fund but how do you know if a fund is performing well?
Let us dive into the topic by starting to know what funds performance is.
A fund’s performance is basically all about how much return the fund generates on an annual basis and what is the cost of earning that return for an investor. This net return on the fund should match with the expected return that the investor is seeking to meet their financial goals. But analysing the past data of the fund is one thing and considering the risk adjusted future returns net of charges is another. Evaluating a fund involves a comprehensive analysis including past performance and future projections.
Therefore, you must include fund performance analysis in the process of picking the right fund. Before we begin knowing about the fund performance, let us look at the significance it holds in our financial planning.
In the field of finance, there is no such thing as ‘invest and forget’. Every type of investment asset needs some kind of reevaluation and analysis to find out if the fund’s performance is still in line with your goals. Therefore, it becomes important to analyze a fund’s performance not only at the time of investing but also from time to time while you are invested. Let us also glance at the below mentioned importance of fund performance analysis.
Now that you understand the importance of knowing about the fund’s performance, let us guide you through the ways in which you can do the evaluation.
Let us consider the following hypothetical example to understand better.
Year | Nifty50 | XYZ Growth Fund |
Year 1 | -8% | -12% |
Year 2 | 15% | 12% |
Year 3 | 20% | 23% |
The XYZ Growth Fund is said to have positive alpha in the third year when the benchmark index gave a return of 20% whereas the mutual fund returned 23% on the capital.
Here’s an example of two mutual funds to help you understand Sharpe Ratio’s application better.
Particulars | Mutual Fund 1 | Mutual Fund 2 |
Return on Investment | 15% | 12% |
Risk Free Return | 4% | 4% |
Standard Deviation | 5 | 6 |
Sharpe Ratio | 2.2 | 1.33 |
Sharpe Ratio is computed by using the following formula:
(Return on Investment – Risk Free Return) ÷ Standard Deviation
If the Sharpe Ratio is less than 1, then the fund is considered bad. Ratio more than one up to 1.99 is good. From 2 to 2.99, the fund is considered very good. Funds with Sharpe Ratio of 3 or more are considered excellent.
In the above example, Mutual Fund 1 is better than Mutual Fund 2 as the Sharpe Ratio is higher.
These are some steps following which you can evaluate the funds before picking one or in case you have already invested, you can evaluate it to ensure that the purpose for which you have invested is being served well.
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