Thursday, 26 May 2016

How to Select Mutual Fund for Portfolio


To select among so many mutual fund schemes, investors must understand how to evaluate past performance and the degree of risk associated with mutual fund. The total return of funds include dividends, capital gains distributions and increase in the NAV (net asset value). To get a clear picture of fund's performance , they should be compared with an appropriate benchmark index, the returns of similar funds available in market. Studying performance over a long period of time , during both bull and bear markets gives a hint as to how the fund will perform in future. 

Risk is an integral part of Mutual funds and you should look into the various risk ratio mentioned below before investing in Mutual Funds and not alone investing by absolute or annualized returns 

Alpha : Alpha is the measure of fund's excess return relative to a market Index. Alpha measures the difference between a fund's actual returns and its expected performance, given its level of risk. A fund's alpha is often considered to represent the value that a portfolio manager adds to or subtracts from a fund's return above and beyond a relevant index's risk/reward profile.

Calculation:-

Alpha = {(Fund return-Risk free return) – (Funds beta) *(Benchmark return- risk free return)}.
Example:
Fund return 10%
Risk free return 8%
Benchmark return 5%
Beta of Fund 0.8
By computing with above formula we will get alpha as 4.4 for this fund

A positive alpha of 1.0 suggest the fund has outperformed its benchmark index by 1%. Correspondingly, a similar negative alpha indicates an underperformance of 1%. For investors, for you the more positive an alpha is, the better it is.

Beta : Beta measure the volatility of fund's return compared to that of benchmark index.
For Example : A beta of fund with 1.2 is 20% more volatile than the Index. It will, on average, rise 20% more when market is increasing and fall 20% when market is declining. A beta of fund with .7 is less volatile than the Index. The fund will give a return of 30% lower than market when market is rising and decline 30% less when it is falling 

Beta = 1, This happens when the stock price movement is same as that of market.
Beta > 1: Beta exceeds one when the stock price movement surpass market movement.
Beta < 1: This happens when the stock price moves less in comparison of market.

Investors willing to take on more risk in search of higher returns should look for high beta investments. 
In case if you want to calculate volatility manually here is the link How to Calculate Daily and Historical Volatility

R-Squared : R-Squared measures whether the fund's price movements are correlated to the benchmark index on a scale from 1 to 100. 
R-squared is not a measure of the performance of a portfolio. A great portfolio can have a very low R-squared. It is simply a measure of the correlation of the portfolio's returns to the benchmark's returns.

General Range for R-Squared:
70-100% = good correlation between the portfolio's returns and the benchmark's returns
40-70% = average correlation between the portfolio's returns and the benchmark's returns
1-40% = low correlation between the portfolio's returns and the benchmark's returns

Index funds have an R-squared nearly close to 100.
A rule of thumb, an R-Squared above 75 typically indicates that the comparison of a given fund to a given benchmark is meaningful.



Standard Deviation
Standard deviation (SD) measures the volatility the fund's returns in relation to its average. It provides information whether you how much the fund's return can deviate from the historical mean return of the scheme. If a fund has a 12% average rate of return and a standard deviation of 4%, its return will range from 8-16%.

Computation:
Standard Deviation (SD) = Square root of Variance (V)
Variance = (Sum of squared difference between each monthly return and its mean / number of monthly return data – 1).

The higher the number, the more volatile is the fund's returns. Investors should prefer funds with lower volatility.



Sharpe Ratio : - Sharpe Ratio is effectively the risk premium per unit of risk. Higher the Sharpe Ratio, better the scheme is considered to be. Care should be taken to do Sharpe Ratio comparisons between comparable schemes. For example, Sharpe Ratio of an equity scheme should not be compared with the Sharpe Ratio of a debt scheme.



Mutual Fund Evaluation Criteria –
Consistent Performance -> Low Standard Deviation; High Sharpe Ratio -> Higher ranked fund

Volatile Performer -> High Standard Deviation; Low Sharpe Ratio –> Lower ranked fund

As an Investor you should not blindly look at the past returns and purchase the funds instead you should look at the parameters above on how to select mutual fund  , do some research and review their performance at a regular intervals

Several Fund rating agency such as CRISIL provides rating system and tools to compare the performance of funds with other funds with similar objective. The most and the important aspect of fund performance is consistency. Investors are advised to choose funds with returns that are ranked above compared to their peers majority of the time

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Disclaimer  :-


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