Monday, January 29, 2007

Work your Way up with your Wealth building Winners! (Contd.)

Work your Way up with your Wealth building Winners! (Contd.)

Performance Evaluation of Mutual Funds (contd.)

Past Performance of the Fund

Though past performance alone cannot be indicative of future performance, it is, frankly, the only quantitative way to judge how good a Fund is at present. By looking at the performance of Mutual Funds over different periods, you can select consistent performers.

Compare returns across Funds within the same category
Compare apples with apples and not with oranges i.e. compare Funds within a category. For instance, if you are evaluating Sundaram Select Midcap Fund for investment, you should compare its returns with other predominantly mid cap diversified equity funds. Comparing it with large cap funds, will deliver erroneous results, because the risk-reward relationship between mid cap and large cap funds are not comparable.

Compare returns against those of the benchmark index
Regulations demand that every Fund mentions a benchmark index in the Offer Document. The benchmark index serves the dual purpose of being a guidepost for both the fund manager and the investing community. All eyes must be on the benchmark index and how the fund has fared against it. During market turbulence, like the one witnessed over May-June 2006, you will find many equity funds trailing their benchmark indices. The funds that can outperform their benchmark indices during stock market volatility must be marked closely.

Compare against the fund's own performance
Besides comparing a fund with its peers and benchmark index, you should evaluate its historical performance. Not all funds show stability in performance over the years. Many of them slip up; only a few manage to sustain the good work they have done year after year, market cycle after market cycle.

As equities are best equipped to deliver returns over longer time frames (3-5 years or even more), investments in diversified equity funds should be made with a long-term perspective. Comparing a fund over a longer time frame will also give you a good idea about how the fund has fared over a stock market cycle (boom and bust).

Do not overrate past Fund performance

One of the most common ways of selecting a Mutual Fund is to invest with the crowd in today's hot funds. Unfortunately, jumping from one winning fund to another is a recipe for disaster. Buying the equity fund that was yesterday's best-seller is not a strategy that produces excellent returns. You do not have to go fully in the opposite direction and ignore these hot funds, but you should understand their limitations and strengths. They became best-selling funds because they have merit, but you have to assess that merit in the context of your own well-diversified portfolio, and not the crowd's current investment trend.

Use past performance to determine consistency and risk

There is an important role that past performance can play in helping you to make your fund selections. Returns for mutual fund schemes are displayed on a compounded annualised basis, especially for periods in excess of one year. While the need to present the returns in the given form is a statutory requirement, you should realise that returns computed using the compounded annualised growth rates (CAGR) can present a distorted picture. CAGR provides a smoothed return i.e. the steady rate of growth. A strong surge at the end of the period can have a positive impact on the historic returns as well. While you should disregard a single aggregate number showing a fund's past long-term return, you can learn a great deal by studying the nature of its past returns. Above all, look for consistent performance.

In using the word performance, I am not limiting my interest solely to return. Risk is a crucial element in investing and the subject matter of the next blog.

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