Most investors see the scheme's one-, three-, five- and ten-year trailing returns relative to the category and benchmark, check the latest portfolio, and find out whether the AMC and fund manager have a good track record. But while these should remain your primary criteria for selecting an equity fund, it is also important to understand how the fund has earned its returns before buying it. Here are five metrics that help you do this.
Most fund rankings are based on trailing three-, five- or ten-year returns of a scheme because these give you the most updated information on a fund's performance till date.
But trailing returns can be heavily influenced by the starting point and the end point of the time period chosen. Market conditions on the date on which you are assessing the scheme also have a big influence on returns.
Therefore, while trailing returns tell you about the scheme's most recent performance, they don't measure consistency or performance across market cycles. To manage outperformance over the long term, a fund should have ideally beaten its benchmark and peers over different market cycles. How will you find that? Take stock of a fund's calendar-year returns over its life. If a fund has a ten-year history, compare the fund's returns to its benchmark and category in every one of those calendar years. This information is directly available in the scheme snapshots on www.ValueResearchOnline.com. Use the calendar-year record to assess specifically if the fund has beaten its benchmark in all or most of the last ten years (since inception, if the ten-year record is unavailable) and whether it has contained losses better than the index/peers in bear markets. This can also tell you a lot about the risk profile of the scheme. A scheme which delivers tearing performance in bull markets but loses its shirt in a bear market will not leave you better off in the long run.
How do you know if a fund manager gets his calls consistently right? Use portfolio-turnover data. Portfolio turnover, which is disclosed in fund factsheets, is calculated as the lower of total stock purchases or sales during a period divided by the average assets of the scheme.
A portfolio turnover of 100 per cent does not necessarily mean that all the stocks in the portfolio have been replaced during the year. It only means that the fund has done purchases or sales amounting to its entire net assets over the year.
A low portfolio turnover (less than 50 per cent) is an indication that the scheme has been following a buy-and-hold strategy. A high portfolio turnover is a sign that the fund has replaced its stocks quite often.
A fund which manages good returns with a low portfolio turnover is your best bet as it shows that the fund manager is able to follow a buy-and-hold strategy because his stock selection works.
When you quiz Indian fund managers about their investment styles, most of them profess to hunt for 'value' or 'growth at a reasonable price'. But only a few really stick to this philosophy. To check if a scheme is chasing growth at any price, it is best to check its latest portfolio P/E.
If a fund's portfolio P/E is much higher than that of the Nifty/Sensex or its chosen benchmark, its claim that it is a value investor does not hold water. Such a fund may also carry higher downside risk in the event of a market correction. Selecting funds with a portfolio P/E that is lower than the market's can also help you de-risk your portfolio when markets are expensive.
Portfolio P/E is calculated on the basis of the P/E of individual stocks multiplied by the weights they carry in the portfolio. Therefore, it is a function of sector choices, too. Commodity and cyclical stocks always trade at a lower P/E than defensive and secular-growth stories.
Though fund labels in India generally revolve around market capitalisation, schemes often stray from their label. While assessing whether you must add a new fund to your portfolio, it is important to check out its market-cap composition.
Small and mid caps have more volatile earnings, carry governance risks and are less liquid than large caps. They compensate for these by offering higher returns. A fund with higher mid- and small-cap allocations may earn a higher return in a favourable market, but that comes with greater volatility and possibly less liquidity. So, if you find a scheme outperforming its category/benchmark by a big margin, do check out whether its mid- and small-cap allocations are in alignment with its category/benchmark.
The Value Research fund snapshot offers a break-up of each scheme's weights across giant caps, large caps, mid caps and small caps vis-a-vis the category and the benchmark.
Best and worst
One of the key assessments any investor makes while evaluating any new investment is its risk-reward equation.
There are many statistical risk measures to help you gauge this. These include measures such as Sharpe ratio, Treynor ratio and Sortino ratio. But these numbers are often Greek and Latin to the layman.
So if you don't have access to this data or can't interpret it, a much simpler way to assess a fund's risk profile is to take a look at its best and worst show over its life. In an equity fund, given that your investment horizon is typically long term, monthly and quarterly records shouldn't matter much. Instead, look at the best and worst annual returns managed by the fund since inception.
This can give you a clear idea of how bad things can get if the markets turn turtle and also how high a return you can expect if a bull run is on. Suppose Fund A has managed a 60 per cent gain in its best year but suffered a 50 per cent loss in its worst one. Fund B has managed just a 30 per cent return in its best year while containing losses to 10 per cent in its worst year. Over the long term, Fund B will turn out a far bigger wealth creator for your portfolio than Fund A. And you will have spent far fewer sleepless nights.