How To Select Best Performing Mutual Funds?

By: Tavaga Research

While zeroing in on a mutual fund as an investment opportunity, various measures can come into play. Some of the widely known measures assess the mutual fund performance based on risk assumed and returns generated. A more comprehensive way to analyze both the factors simultaneously is to look at the fund’s risk-adjusted returns. In addition to the risk-adjusted performance of the fund, the fund is likely to pose fund-specific factors such as Total Expense Ratio (TER) and Fund Strategy. 

Return Measures

1. Historical Performance: The most important yardstick that lets an investor shortlist a mutual fund is its historical performance. While historical returns do not guarantee future performance, the returns do indicate the fund’s appeal and competence when compared with other funds within the same category. However, the notable drawback of considering historical returns is that historical performance does not let the investor get a picture of the consistency of returns. For example, yearly returns of a fund may be driven by extraordinary outperformance during a few months, which do not sustain throughout the year.
2. Attribution Analysis: Attribution analysis is a detailed process of understanding whether the fund’s return adheres to the fund philosophy and is directly influenced by the fund manager’s strategy. Attribution analysis is understanding the source of returns, which can be one of the three: Allocation to sectors, Specific stock selection, and/or an interaction of the two. An aggregate of these returns yields the active returns created from the fund.

A fund may have underperforming sectors but stocks within sectors that lead to excess returns generated by the fund. In such a case, the fund manager’s skill is a result of stock selection and is said to follow a bottom-up strategy. Therefore, attribution analysis is used to understand the concurrence between the fund returns and the fund manager’s investment strategy. For example, a fund with a top-down approach must be supported by the fund’s returns coming from sector allocation, and not specific stocks within the sector. Attribution analysis also reveals the active performance of the fund, which is crucial for actively-managed funds.

Risk Measures

1. Standard Deviation: Standard Deviation (SD) is a measure of risk that measures the deviation of returns from the mean returns. SD of the mutual fund lets the investor understand the expected volatility in the fund’s returns. For example, if a fund has an SD of 5 percent and an expected return of 15 percent, the actual returns may vary between 10 percent and 20 percent. However, the computation of SD is based on the historical performance of the fund. SD must be used in conjunction with other measures for a comprehensive analysis.
2. R-Squared (R²): R-squared is a statistical measure of the percentage of fund’s returns that can be explained by the movements in the fund’s benchmark. R-squared determines the similarity between the fund and the fund’s benchmark. R-squared can be used by investors to:
   • Create a well-diversified portfolio of mutual funds by reducing the repetition of exposure to sectors. For example, for an investor who holds a fund with a high R² to the Nifty 50, the ideal strategy will be to increase exposure to funds with lower R² toward Nifty to avail the benefits of diversification. Monitoring the portfolio for this measure can significantly reduce fund overlap, and thereby
   • Review existing funds for any style drift toward that of the benchmark. An actively-managed is supposed to outperform the benchmark and not mimic the performance of the benchmark. Therefore, if the R² measure is high, it means the returns of a fund are highly correlated to that of the benchmark essentially reducing the fund’s ability to create alpha.
3. Up and Down-market capture: Up-market and down-market captures are to mutual funds what a beta is to stock. Market captures measure the fund’s sensitivity to index or benchmark movements. Market capture ratios are ideal measures to analyze how the fund value moves with respect to the overall market. A higher up-market ratio of, say 130, means that the fund outperformed the market by 30 percent.
4. A higher up-market ratio and a lower down-market ratio makes a fund attractive. An up-market ratio divides the cumulative positive returns of the fund with that of the market. The higher the ratio, the more the outperformance of the fund. For the down-market ratio, cumulative negative returns are considered. The ratio points to the fund manager’s ability to capitalize on a rising market and safeguard capital in a falling market.

Risk-adjusted Returns

Risk-adjusted returns incorporate the theory of risk-return trade-off in that a higher degree of risk demands higher returns. Risk-adjusted returns use a measure of volatility to specify the risk undertaken. Popular risk-adjusted return metrics are:

1. Sharpe Ratio: Sharpe Ratio measures the excess return generated by the fund for every additional unit of risk. Excess return is defined as the fund’s return over the risk-free rate of return. The unit of risk is the standard deviation. The higher the Sharpe ratio, the greater the fund performance. Sharpe Ratio is used as a relative measure and has to be compared across similar funds to identify outperforming funds.
2. Sortino Ratio: Sortino ratio is similar to the Sharpe ratio in that the Sortino ratio also is a relative measure and uses excess return as one of its inputs. The key difference is that the Sharpe ratio uses the total volatility as a measure of risk whereas the Sortino ratio uses downside deviation as a measure of risk. Downside deviation measures only the downside risk of investment thereby capturing the volatility that is likely to hurt an investor. A higher Sortino ratio is favorable and signifies a lower probability of an adverse movement in the mutual fund value. The Sortino ratio is an ideal measure for risk-averse investors, who are more concerned about the downside risk. The ratio should be considered in the context of the investment horizon and risk tolerance. Higher returns may not offer a favorable Sortino ratio.

Fund-specific Factors

• Style Analysis and Drift: Style analysis involves determining the investment style of the fund manager. Investment styles can be of varied types and depend upon the market capitalization and valuation of the stocks. The most common forms of styles are growth investing, value investing, and active trading. Growth investing is focused on stocks to gain momentum in the near-term owing to above-average growth in earnings. On the other hand, value investing is not as aggressive as growth investing. Value investing is focused on stocks that are undervalued relative to their fundamentals and required the fund manager to be invested for a longer-term. Active trading is the most aggressive strategy and is accompanied by high portfolio churning.

Style analysis is the most meaningful when used to assess the Style Drift of the fund manager. Given the track record of the fund, an investor can map the style of the fund to the actual style adopted by the fund manager. A fund’s style is a reflection of the investor’s risk tolerance. Therefore, any style drift is likely to alter the risk assumed by the investor. 

• Turnover Ratio: The turnover Ratio is an indicator of how often a fund manager buys and replaces securities for a fund. Turnover ratio is the number of securities replaced expressed as a percentage of the total number of stocks that the fund invests in. For example, a fund invests in 75 securities in a year and replaces 15 of them. The turnover ratio would be 20 percent. The turnover ratio is typically high for actively managed funds and low for index funds. The turnover ratio directly impacts the net returns from the fund as higher portfolio churning increases the transaction costs.
• Total Expense Ratio: Expense ratio implies the percentage of AUM deducted as annual charges of operating the fund. TER includes management fees, administrative fees, brokerage costs, and legal costs. The expense ratio reduces the net return available to an investor. A higher TER does not mean superior performance.

Taxation on Mutual Funds

Redemptions or withdrawals and dividends are the cash flows associated with a mutual fund investment. The cash flows are taxed differently for equity and debt schemes and differently for long-term and short-term gains. 

Funds	Short-term Capital Gains	Long-term Capital Gains
Equity	<1 year	>=1 year
Balanced	<1 year	>=1 year
Debt	<3 years	>=3 years

Tax on Equity Mutual Funds

Equity Linked Savings Scheme (ELSS) are equity mutual funds that qualify for tax exemptions under Sec 80C of the IT Act. However, other equity mutual funds lead to short-term capital gains and long-term capital gains. Balanced funds are taxed as per the norms applicable on non-tax savings equity funds as balanced funds are mutual funds that invest 65 percent of AUM in equities.

Tenure	Tax Rate
STCG	15 percent
LTCG	Exempted for redemption up to Rs 1,00,000; 10 percent tax on redemption more than Rs 1,00,000

Tax on Debt Mutual Funds

Tenure	Tax Rate
STCG	Returns added to income and taxed as per the applicable slab rate of the unitholder
LTCG	20 percent after indexation benefits

Tax on Mutual Fund dividends

Dividends from mutual funds are taxable in the hands of the investor as per the applicable tax slab.

While mutual funds offer the benefits of diversification, they are still prone to market risks. Recent fiascos in the mutual fund space, such as Franklin Templeton’s premature closure of funds, have shaken the investors’ faith in mutual funds as an investment vehicle. Rightly so, investors must exercise caution when selecting funds. Factors such as NAV and short-term performance don’t help an investor make a decision. Due diligence is necessary when it comes to analyzing the manager’s tenure and contribution to the success of the fund. Fund managers can tip the scales in any direction. Therefore, if the fund is performing well owing to the manager’s skill, the manager’s tenure is in the best interests of the investor. Also, checking the number of holdings in the fund will help an investor make a prudent decision. Funds must not pose concentration risk in that a significant percentage of AUM must not be invested in a single stock. Defaults as massive as IL&FS default are capable of taking any fund’s NAV to near-zero levels. Market risks are amplified in actively-managed funds.

Therefore, exchange-traded funds (ETFs) and index mutual funds appear a smart choice for risk-averse or long-term investors. ETFs are passive investments, which means the fund manager is attempting to mimic the performance of an index. ETFs, demand a minimum expense ratio. ETFs also offer tremendous liquidity as they are traded on the stock exchange. ETFs offer the best opportunities for a buy and hold strategy. 

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