July 19, 2019

5 Key Ratios to help you choose the best fund for your client

Saurabh Mittal

Founding Director Circle Wealth Advisors Pvt Ltd

5 Key Ratios to help you choose the best fund for your client

It’s often tempting to find a new way to research a mutual fund or to look at it from a different angle. Since it’s in an advisor’s interest to find a mutual fund that will create wealth for investors in the long run. That’s why we look for the best performing mutual fund.

Yet, the best performing mutual funds in our industry change from time to time, tempting us to challenge our existing method for research.

‘There are more ways than one to skin a cat.’ – The Money Diggers, 1840

There are multiple ways to analyze a mutual fund. For instance, speaking with fellow advisors, using mathematical ratios, meeting with a fund manager and many more.

In this article, we will focus on using simple mathematical ratios to analyze a mutual fund. There are multiple ratios yet an advisor must keep them to 5 or 6. Over-analysis can lead to paralysis. Keeping it simple is absolutely important.

A look at some Mutual Fund Ratios

1. Standard Deviation

In simple terms, it assesses the volatility of the fund. It tells us how much the return of a fund can deviate from its historical mean.

Lesser the standard deviation better is the investor experience. As advisors, we are sometimes obsessed with chasing high returns and tend to forget the risk we take along in the journey. In a bull market, it’s not a problem. Every investor loves to take risks. But then the tide turns and a fund falls more than its underlying benchmark, then the same risk-taking investor becomes risk-averse.

Take the classic case of Nifty50. It has delivered fantastic returns in the past couple of years. So much so that suddenly everyone has started talking about Nifty ETF. But it has a standard deviation of 13.86. This simply means, if Nifty’s average return over the last 1 year has been 12%, then in the current year it can be either 25.86% or -1.86%.

This doesn’t mean that Nifty50 is a bad investment. But while investing in a Nifty ETF, an advisor should know the extent of volatility.

2. Sharpe Ratio

Sharpe ratio shows what return is earned at the level of risk taken. The ratio is the average return earned in excess of the risk-free rate, per unit of volatility.

So if a Sharpe ratio of a fund is 0.5, it can be understood that for every unit of risk taken the fund has generated half amount of return. Hence more the Sharpe ratio is better. A Sharpe ratio of 1 is a very ideal situation. Any fund with a Sharpe ratio near 1 indicates that return is at par with the risk it is taking.

3. Beta

In layman terms, Beta can be understood as the sensitivity of an investment return (stock / mutual fund) compared to the market as a whole. Hence, the beta of a benchmark would always be 1, which denotes absolute sensitivity to itself. Hence, a fund with a beta greater than 1, is more volatile than the benchmark and less than 1 is less volatile than the benchmark.

For example, if the benchmark of the fund goes up by 1% then the fund with a beta of 0.75 will go up by 0.75% and will fall by 0.75% too when the benchmark goes down by 1%.

As advisors, we thrive to reduce the risk of our investors. In an ideal world, we should be invested in high beta funds when the market is bullish to make the maximum return and inversely in a low beta fund when the market is bearish to minimize the losses. It’s easier said than done. Eventually, we should create a portfolio with an investors risk profile in mind. In the long run with buy and hold strategy, we feel that low beta portfolio would tend to do better as compared to a high beta portfolio.

4. Alpha

At the end of the day, it’s the hunt for Alpha! As financial advisors, we seek to create excess returns over the benchmark. Investors and we advisors obviously love to see the alpha being created in the portfolio of our clients. But let’s understand that Alpha is not simply the return of funds generated over and above the benchmark returns.

Alpha in effective terms is excess returns calculated on a risk-adjusted basis. It’s important to note that an active fund manager’s job is to create excess alpha on a risk-adjusted basis and not merely excess returns over its relevant benchmark.

For example,
Fund 1 & 2
Fund return 10% in both cases
Benchmark Return 8%
Risk-free return 6%
Fund 1 beta 0.8 and Fund 2 beta 1.2
So Alpha of Fund 1 = (10-6)-(8-6)*0.8 = 2.4
Alpha of Fund 2 = (10-6)-(8-6)*1.2= 1.6

5. R Squared

The R-sqaured number demonstrates the quantum of a fund’s movements that can be explained by the movements in its benchmark. A higher number would indicate the performance of the fund with the performance of its benchmark.

Values range from 0-100.

A mutual fund with an R-squared value between 85 and 100 has a performance record that is closely correlated to the index. However, a fund rated 70 or less typically does not perform like the index.

Conclusion

To reach our goal of creating a long-term sustainable wealth for clients, simply tracking the historical outperformance of a mutual fund scheme will not be enough. It’s important to select a mutual fund that creates Alpha with a standard deviation lower than the benchmark.
Also selecting the fund with lower Beta and a higher Sharpe ratio. Combining the funds with different properties can help in creating an ideal portfolio which matches customers risk profile and return expectation.

For an investor higher returns matter in the short term but in the long term the tendency shifts towards lesser risk in the portfolio. As his money grows, he tends to become more risk-averse. Even a temporary negative 5% in the portfolio may result in a sleepless night, as they are not wired to look at their returns in % manner, they look at it in absolute rupee terms.

As advisors, if we tend to focus on reducing his risks from day 1, then the investment journey becomes smooth and happy for both of us. It’s important to critically analyze a fund manager using the above 5 ratios as that will give an advisor the comfort of long term returns with a Win/Win situation for everyone.