Monday, February 05, 2007

Performance Evaluation of Mutual Funds (contd.)

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

Performance Evaluation of Mutual Funds (contd.)

Understand the risks...

THAT risk and return are two sides of the same coin is an old cliché but highly relevant in the context of Mutual Fund performance. The performance assessment of Mutual Funds should be based not only on how much a Fund gains in a bull market, but also on how gradually it falls in a bear market. This throws light on the importance of reducing risks in a falling market. But the task of the Fund Manager to add value cannot be underplayed. A fund manager who reduces risks by booking profits has also to be careful in reinvesting. If the reinvesting is badly managed, the returns may not be superior.

In general, Mutual Funds are not considered to be too risky because they invest in dozens or even hundreds of stocks. But Mutual Funds being market-linked, are prime candidates for stock market related risks. The four aspects that you should take into account while analyzing risk in Mutual Fund investment are volatility of the fund as indicated by the Standard Deviation, risk-adjusted returns as calculated by the Sharpe Ratio, Beta and Alpha. While Standard Deviation shows the degree of risk taken on by the fund, Sharpe Ratio shows the return generated by the fund per unit of risk taken. Beta shows how much a fund moves when compared to an appropriate index. Alpha represents the difference between a Mutual Fund's actual performance and the performance that would be expected based on the level of risk taken by the manager.

A Fund with low risk is the one with the lowest Standard Deviation, the highest Sharpe Ratio within its peer group, Beta closer to one and Alpha above one. It is advisable for you to evaluate these measures on a historical basis so as to identify the most consistent performers. Such rigorous research is done by some Mutual Fund sites like Valueresearch which rate the risk profile of Funds on a five-point scale.

While no amount of research can guarantee future fund performance, it certainly can reduce the likelihood of unintended risk by carefully analyzing and interpreting risk statistics. In a declining market, sometimes this understanding may just provide the marginal comfort that separates those who ride out storms from those who do not.


Diversification can reduce risk. Depending on your risk tolerance and how long you will be investing it may be advisable to own some Equity Funds and some Bond Funds. Select funds in each asset allocation category and spread your investment. You might not get as much diversification as you think if all your funds are with the same AMC, since they may share research and recommendations. The same is true if you have multiple funds with the same profile or investing strategy; their returns will most likely be similar. Too many funds, on the other hand, will give you about the same effect as an index fund, except that your expenses will be higher. Don't underestimate the value of diversification by putting all your money into one single fund. People who put all their eggs in one basket may come home to find someone has been making scrambled eggs in their kitchen.

Like any other investment, Mutual Fund investing also has a lot of risks involved. Though the funds are managed by professionals and fund houses have adequate risk management policies in place, understanding the various risks involved in investment strategies adopted by fund managers will help you in choosing the right scheme depending on your risk appetite.

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