Assessing fund performance: Run the numbers, then do qualitative checks

The Securities and Exchange Board of India (Sebi) recently issued a circular directing mutual fund houses to disclose the information ratio, a measure of risk-adjusted return, for all equity-oriented schemes. The objective, according to Sebi, is to offer a more comprehensive measure of a scheme’s performance. Let us turn to the key measures investors should use to evaluate performance.

 

Trailing return 

This is the most commonly used performance metric. “It is easy to understand and is commonly available. It tells you that if a fund has not beaten its benchmark over a sufficiently long horizon, you should not be invested in it,” says Deepesh Raghaw, a Sebi-registered investment adviser. 

This metric, however,  suffers from start and endpoint bias. If the market was at a high at the start and at a low at the end of the period, trailing returns will appear poor. “It also doesn’t take into account volatility,” says Kaustubh Belapurkar, director-manager research, Morningstar Investment Research India. 

Rolling returns 

Rolling returns address the bias inherent in trailing returns by calculating returns over multiple periods. A fund’s three- or five-year return rolled daily could be calculated over 10 years and compared against similar figures for its benchmark.   

“This exercise will tell you what percentage of times the fund has beaten its benchmark. If that figure is high, it amounts to a good performance,” says Raghaw. Next, the fund's average of all these data points should be compared with the average for the benchmark. “Rolling return is a phenomenal way to assess a fund’s performance,” says Raghaw. 

However, accessing this data can be difficult for retail investors as it is usually available on paid platforms. 

Risk-adjusted returns 

While returns matter, so does volatility. “If the journey becomes too turbulent, investors tend to exit a fund,” says Raghaw. Measures of risk-adjusted returns evaluate the return a fund manager has generated per unit of risk. “These measures tell you: If a fund has delivered a higher return, is it because the fund manager took additional risk, or did she deliver a good return with minimal risk?” says Belapurkar. Several measures of risk-adjusted return exist: 

• Sharpe ratio: While the numerator contains the fund’s return minus a risk-free rate, the denominator contains the standard deviation of the portfolio. A higher Sharpe ratio indicates better performance per unit of volatility. 
• Sortino ratio: The Sortino ratio focuses solely on downside risk since it is the downside, not upside, deviation that hurts investors. The numerator contains the portfolio return minus the risk-free rate. This is divided by the downside deviation (the standard deviation of negative returns, or returns below a defined thres–hold, typically the risk-free rate).  
• Information ratio: The numerator calculates the alpha, or a fund’s outperformance vis-à-vis its benchmark. The denominator calculates the tracking error or the standard deviation of the difference between the fund and benchmark returns. 

Limits of quant metrics 

Rely on multiple metrics to derive a holistic picture of performance. Also, compare a fund’s performance with its category peers or the appropriate benchmark. Belapurkar recommends using qualitative metrics to narrow down options, then supplementing with qualitative evaluation. “Numbers do not reveal changes in fund management, style deviations, etc.,” he says.  

Raghaw suggests checking fund size and the fund manager’s tenure: Past returns are meaningless if delivered by 

a different fund manager. Belpurkar advises checking the strength of the fund manage–ment team,  and ensuring it follows a consistent process. 

Red flags

  Investors often select funds based solely on one-year performance

  Recent outperformers might belong to categories that don’t match the investor’s risk appetite

  Investors may enter those funds late when returns have already peaked

  Investors must avoid unrealistic return expectations based on recent performance

  They must avoid frequent switching between funds unless there is a material change (e.g., in the fund manager or investment style)