How do I analyze a Mutual Fund?

Well, this is one topic which a lot of folks want to know about - How do I analyze a Mutual Fund and decide which one to opt for??

So today, I’ll tell you how I analyze any Mutual Fund before investing or recommending it to a client.

(Please note that there is no golden rule to analyzing a Mutual Fund. This is what I follow, and different people use different methods to evaluate).

First, if you don’t know what a Mutual Fund is, please read about it here. As a young investor, a Mutual Fund is a must-have in your overall portfolio. Also, if you’ve not read the previous 3 articles on Mutual Funds, and want to clear your basics about Mutual Funds, do make sure you read them before you go forward. It’ll help get a clearer understanding of the different jargon in a Mutual Fund. The third article in the series can be found here, and it has back-links to the other two articles. Trust me, each of these articles won’t take more than 7 minutes. Which means, 30 minutes is all it’ll take for you to understand and analyze a Mutual Fund. The time will be totally worth it!

But if you know the basics, you can continue with this article.

Let’s cut to the chase. If I’m analyzing an equity Mutual Fund, this is what I look at:

1. Past returns: Disclaimer - Past returns are in no way an indicator of future performance, but they give me a place to start. If a fund has given bad returns in the past, there’s a very low chance of it giving good returns in future. So this is where I start. It’s good to check out “Rolling returns” of the Mutual Fund, along with point-to-point returns. Rolling returns essentially are returns from point A to point B, which means that if I’m checking 5-year rolling returns backwards from 15th August 2021, I will get returns as per the below:

   • Returns from 15th Aug 2016 to 15th Aug 2021

   • Returns from 14th Aug 2016 to 14th Aug 2021

   • Returns from 13th Aug 2016 to 13th Aug 2021, and so on

   Basically rolling returns are more accurate, as they show you returns for each date. Why this is more accurate? Because if you see returns of your Mutual Fund on 20th February 2020 and 20th April 2020, in just that 2-month timespan, your MF portfolio would have fallen 25-35%. Therefore, instead of seeing 5 year returns on random dates, it’s better to see 5-year rolling returns, which will show you returns on each date, and therefore give you a more accurate picture.

   Now, returns cannot be viewed in isolation. A higher return fund may not always be the best fund, since the higher return comes with a higher risk as well. So we need to look at other metrics holistically and then decide. I personally don’t choose an equity Mutual Fund that has given less than 9-10% returns in the past.

2. AUM: This is the Asset Under Management, or the fund size - how much money does the Fund Manager have from people like you and me, to invest further (if you don’t know what AUM is, you can quickly check it out here).

   So, if a Mutual Fund has a low AUM, that fund may not really be a priority for the Mutual Fund house, so I generally avoid very funds with very low AUM. On the other hand, while a higher AUM is good, a very high AUM may also cause problems. A very high AUM means that the fund manager will necessarily have to put money in more companies. This could be a problem when the Fund Manager wants to sell some stocks that he has purchased, because he/she will then need to find so many buyers who will buy the stock at the given price. Therefore, I avoid very high AUMs (above 15K crores) unless the fund has great fundamentals otherwise.

3. Turnover Ratio: This denotes how frequently the fund manager has changed the holdings (or stocks) of the Mutual Fund. So for example, if the Fund Manager has bought stocks worth Rs. 100 crore and sold stocks worth Rs. 50 crore, and the total AUM of the fund is Rs. 1,500 crore, then the Portfolio Turnover Ratio would be (100cr + 50cr)/1500cr = 10%. The turnover ratio should generally not be too high, as that may indicate that the fund manager is constantly changing the portfolio and is probably picking stocks he/she is not sure of. I personally look for funds with a moderate turnover ratio - anything between 15% and 30-35% is okay. I generally avoid funds with turnover ratio > 50%, unless everything else is great. Also, do check the category turnover ratio to understand how this fund compares with the category

4. Holdings: This is pretty important. It shows which companies the Mutual Fund has invested in. Now, you need not see the performance of every company and analyze it, because if you knew how to do that, you’d rather invest in the company directly, than via Mutual Funds. But what you do need to see, is that if you’ve invested in multiple Mutual Funds, the holdings should not be the same. Sure, there could (and will) be some overlap. But don’t invest in 2 funds where the holdings are very similar. This means that you’ve not really diversified your portfolio, as your portfolio eventually depends on the SAME companies. Choose funds whose holdings cover a wide range of companies when all are put together. If you’re choosing your first fund, this doesn’t matter. It matters only when you have multiple funds.

5. Standard Deviation (SD): This indicates how volatile the Mutual Fund is, compared to the average returns during a given period. If you want to know about SD, please read the previous post here). Basically, you need to see how volatile the fund is. A higher SD indicates more volatility, but is not always bad, since it also indicates probability of higher returns. So when I check this, I generally see how high the SD is, and how high the returns are, both compared to the category. If the fund is more volatile, it should be rewarded with higher returns. Else the high risk is not worth it

6. Beta: Beta denotes how volatile the fund is with respect to the benchmark. A beta value =1 means that the fund is similar to the benchmark index. A value <1 indicates that the fund is less volatile, while a beta >1 indicates that the fund is more volatile compared to the index. Again, higher volatility indicates higher risk, but should also have the potential to generate higher returns. So while I’m analyzing the fund, I see that if the beta of the fund is high, the returns also should be high. There’s no point in investing in a fund with a high beta and low returns.

7. Alpha: This ratio indicates the additional return that the Mutual Fund is earning with respect to the benchmark. If the value of alpha is 0, that means it is earning returns that are equal to the benchmark. A value greater than 0 shows that the Mutual Fund has generated returns higher than the benchmark, and a value less than 0 indicates that the benchmark returns are better than this fund’s return. Again, let’s not get into the mathematics and complicate it, but there’s one point to remember - it is not just the pure difference between fund returns and benchmark returns (for example, if fund return = 12% and benchmark return = 10%, then alpha is NOT simply 12%-10%. Alpha takes the risk into account and then assigns a value, so it won’t be exactly 2%, but somewhere near that. In essence, it indicates how much more returns the Mutual Fund is giving, with regards to the benchmark (after adjusting the risk taken by the fund). Therefore, when I’m shortlisting a Mutual Fund, I see that the alpha value should be high. Only then does it make sense investing in the Mutual Fund. If the alpha value is <=1, then I’d rather invest in an index fund rather than the Mutual Fund. Also, try and check the category alpha and see that your current fund’s alpha is near about, or better than the category’s alpha

8. Expense Ratio: Well, one of the most important things that people look at (sometimes, the only thing people look at) is the expense ratio of the fund. Expense Ratio, as the name suggests, is the percentage of AUM of the Mutual Fund that goes into expenses. So if a fund with an AUM of 1,000 crore has expenses worth Rs, 15 crore, the expense ratio is 1.5%. (Here is a more detailed explanation of Expense Ratio).

   Typically, the expense ratio of a direct fund is about 1% or less, and that of a regular fund is 1.5-2.5%. In extreme cases, the expense ratio may also cross 2.5%, but the way I see it, if the fund is giving exceptional returns, I don’t mind paying an exceptional expense ratio. Contrary to what people think, I don’t give too much importance to the expense ratio, unless the fund’s expense ratio is way higher than the category’s average. If it gives me good returns, I don’t mind paying the fund a higher fee.

9. Sharpe Ratio: This ratio essentially indicates the return that the fund is giving for each unit of risk that is taken (you may quickly read the details here). This is generally used to compare two funds, and a ratio greater than 1 is good - higher the better. I usually just give a quick glance at this ratio, because the other parameters anyway tell me how much return the fund is giving with regards to the risk taken.

10. Fund Manager: I typically take a glance at the Fund Manager, his past performance, experience and returns given by other funds that he has managed. This is a completely subjective evaluation, so I don’t spend too much time on this, but I do make sure that I’m not entrusting someone with low experience or a not-so-great past with my money. Essentially - I just notice if there are any red flags, else I go ahead.

11. Capture Ratios: This is an important (and one of my favorite) ratio that I see on the MorningStar website (MoneyControl and valueResearch don’t show this). Capture ratio is an awesome metric. There are 2 ratios - upside capture ratio and downside capture ratio. They indicate the performance of the fund when the index has risen and fallen respectively. The standard value is 100. An upside capture ratio over 100 indicates a fund has generally outperformed the benchmark during periods of positive returns for the benchmark. Meanwhile, a downside capture ratio of less than 100 indicates that a fund has lost less than its benchmark in periods when the benchmark has been in the red. Therefore, upside capture ratio above 100 means a fund is performing better than the index when the index has risen, but a downside capture ratio of above 100 means it is doing worse than the index when the index falls. Therefore, upside capture ratio should be >100 and downside capture ratios should be <100. Now, you may have guessed that a lot of funds with a high beta, could typically have both capture ratios above 100, since the fund is more volatile compared to the index. A great fund is one which has a high upside capture ratio and a low downside capture ratio.

One important thing to note is that you cannot evaluate each of these ratios and parameters in isolation. You need to see all of them together, because a high beta or high turnover ratio can be forgiven if the fund has given consistently high returns, or a fund with not-so-high returns can be invested in by low-risk investors, if it has really stable parameters and low volatility. We need to view all parameters together, and then decide.

Yes guys, that’s it. This is all I do to analyze a Mutual Fund. I just input the ratios in a spreadsheet to get a bird’s eye view and then decide whether I should go ahead with investing in this fund or not. If you want the spreadsheet which has a summary of all these ratios, please like and comment on this article with your email ID, or revert to this email (if you’re reading this on mail), and I’ll share the framework summary with you :)

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