Most of us while selecting a mutual fund scheme for investments look for recommendations from friends, browse through various tips given on different websites and take a decision based on the ratings given by different agencies. We hardly try to evaluate a scheme based on its analytical parameters. Although there are different parameters to evaluate any mutual fund scheme to say Standard Deviation, Sharpe ratio, Sortino ratio etc, we shall discuss two main technical parameters which can give us fairly good idea about any equity based mutual fund scheme.
It is a measure of a particular mutual fund scheme’s price (NAV) movements (upward and downward) in relation to it’s benchmark index. Beta of a fund is defined as the excess returns of the fund over the risk free rate as compared to the benchmark index . Let me explain this with the help of an example. Let us assume we get 7% interest from our Fixed Deposit. This is the risk free rate because we do not take any risk when investing in Fixed Deposit (Normally risk free rate is taken as current treasury bill rate). Let us further assume that we have invested in a fund whose benchmark index is Nifty 50 and the beta is 1.5. If Nifty 50 rises by 10%, how much return can we expect from our fund? We shall use this formula to find out expected returns.
Return of Fund = Risk free return + Beta x ( Return of Benchmark index – Risk free return)
In this example Return of fund = 7% + 1.5 x ( 10% – 7%) = 11.5%
What happens when this Nifty 50 benchmark index falls 10%
Return of Fund = 7% + 1.5 x (-10% – 7%) = -18.5%
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 when markets go down. 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. We should select funds with higher or lower beta based on our risk appetite. If we have an aggressive goal and high risk appetite, we can select high beta funds; on the other hand if we are less aggressive and want more stability in our portfolio we should select a low beta fund.
This is the single most important analytical parameter of evaluating any 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. Mathematically we can say
Return of Fund = Risk free return + Beta x ( Return of Benchmark index – Risk free return) + Alpha
If we compare two formulas ( Beta and Alpha), Alpha is the value addition by the fund manager for the same amount of risk taken. In the above example instead of fund giving -18.5% returns in case of 10% fall in Nifty 50 index, had it given -16.5% returns, the alpha would have been 2.
Top performing funds which have outperformed consistently over a longer period of time will have high Alpha. If a fund manager has generated high alpha, it is quite likely that he or she will generate high alpha in future as well. High alpha speaks of the fund manager’s ability of pick up good stocks while constructing a portfolio. We should always look for those mutual fund schemes which are having high Alpha.
As I have already explained in my earlier article, there are two main risks in debt funds namely, interest rate risk and credit risk. If we are able to select the right schemes based on these two risk factors, then debt funds can help us meet our specific investment needs. Accordingly, in our view, the two most important analytical measures for selecting debt mutual funds are modified duration and credit quality.
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 investors 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. Risk and returns are directly related. If we want to get more returns by taking more risk, select a fund with high modified duration, but if we 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 us 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 duration are less than 1 year fall in the money market category – these are very low risk schemes and the returns are also lower.
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.
We should select funds based on credit quality, as per our risk appetite. If we have low risk appetite, select funds which have 80% or more of their bond / NCD portfolio in AA or higher rated securities. However, we 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 we want to capture an extra few percentages of yield we can invest in credit opportunities funds, which have a higher proportion in lower rated papers, but as always, we should be fully aware of the risks. It may not be advisable to take such risks for gaining few extra basis points of return. We must caution 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 has been a case like this in recent past where AAA rated IL&FS defaulted on its credit payments.
It is our endeavor to empower investors with knowledge to take the best financial decisions, as per their needs. Hopefully these articles help you increase your knowledge about mutual funds, clarify doubts and focus on really important factors while doing investments in mutual funds. As always , in case of any doubt or need assistance, please feel free to reach us. We are always there for you.