Mutual Funds are the main vehicle of investment in equities for the majority of Indians. So, it is necessary to know how the mutual funds work and how to evaluate the returns achieved by the fund manager, and where they are lagging.
There are various types of Mutual Funds schemes that are monitored by various highly skilled fund managers. They receive investments from various investors and invest them in securities stocks, gold/ gold bonds, bonds, and various other assets. There are various types of mutual funds like money market funds, debt funds, balanced funds, and hybrid funds. Mutual funds are the largest proportion of equity in US markets. It is the main vehicle of investment in equities for the majority of Indians. So, it is necessary to know how the mutual funds work and how to evaluate the returns achieved by the fund manager, and where they are lagging.
There are two types of Fund manager based on how they select stocks/bonds. This selection also depends on the psychology of the fund manager and how the person thinks about the investing.
1. Top-Down Approach
2. Bottom-Up Approach
Top-Down Approach:
They focus on macroeconomic trends, by checking global trends and the economic impact of any particular event. After that, they select a particular stock favoring the conditions. Asset Allocation creates a major impact on the extra returns earned on the benchmark which is based on a top-down approach. Analysis is done on the basis of
– Interest Rates decided by RBI
– GDP Growth
– Inflation
– Subsidies by government (For Particular sector)
– Bond Yields
High Bond yields lead to less investments in the stock market which can lead to bearish market conditions. Disadvantage of this approach is that during economic slowdown fund manager’s may not have expertise in selecting the right company in the well performing sector because they are performing the majority of work in selecting the right sector to invest in.
Bottom-Up Approach:
It is exactly opposite to the Top-Down Approach.They generally focus on fundamentals of stock like earnings, market cap, dividend yield, and plans for the future. They ignore the majority of macroeconomic indicators. Security Selection creates a major impact on the extra returns earned on a benchmark which is based on a bottom-up approach.Things which fund managers take care while investing in a particular stock.
-Good Corporate Governance
– Low p/e ratio in comparison with peers
– High Return on Equity(ROE), Return on Capital Employed(ROCE)
– Growth in Revenue & Net Profit
– Free Cash Flows
– Future Prospects
During high volatility the Bottom-Up approach shouldn’t be adopted because the person does not know the consequences of it on the particular stock.This approach requires on ground research because one can’t predict whether earnings of a particular company is going to increase or not by just going through past financial reports. Even future prospects can give you an idea of what a company is going to do but you can’t predict how a company is going to execute that particular plan without on ground research.
Here we are going to talk about how to evaluate a mutual fund scheme’s performance. The performance of mutual fund schemes depends upon these 3 aspects:
1. Asset Allocation
2. Security Selection
3. Interaction of both
Asset Allocation:
There are various types of assets like stocks, bonds, debt funds, real estate (REIT), and various other assets. Fund managers allocate weightage according to the market conditions and investor’s risk appetite. The investor has to monitor the fund manager’s allocation to different assets and how they are performing in comparison to bench-mark (Index) returns. Asset allocation is also based on geographically diversified investments. For example, the Indian Fund Manager can invest in US stocks as well.
Security Selection:
It is based upon the sectors selected in particular assets. For example, in stocks a fund manager chooses to invest in the pharma sector, in real estate invests in lands. Performance depends on which sector performs better for a particular time duration. It is the fund manager’s responsibility to change the selection according to the opportunities available in the market.
Interaction:
It is the combined effect of both Asset allocation & Security selection. It evaluates how both of them worked together.
Now Let’s see how to evaluate mutual fund performance mathematically with the help of an example.
Attribution Analysis:
Wi=Benchmark weightagewi=Portfolio Weightage
bi=benchmark returns
ri=Portfolio Return
Here we will have a summation of all the sectors. The impact of these points leads to better/worse results. It is decided based on a benchmark.
Benchmark is the standard weightage that should be allocated to assets and standard returns expected from a particular sector. Benchmark is generally the returns measured from an index.
Here we will understand with a practical example. In image below it shows the returns when invested under the benchmark weightage and returns.
Step 1: To Calculate Contribution for Benchmark:
Contribution is calculated by multiplying weightage and returns achieved from that particular sector. The Sum of contribution will be the Return on investment earned on the benchmark portfolio. Which is equal to 4.954%. In the image below Weightage shows the fund manager’s weightage in that particular sector and returns achieved from that particular sector.
Step 2 : To Calculate Contribution for the Portfolio of a Fund Manager:
As we did it for bench-mark we got the overall returns of 5.117% for the portfolio. This means that the fund manager outperformed the benchmark and performed well overall. Fund outperformed with α=0.163% (5.117-4.954) of returns. A person should invest in the fund having positive alpha. (α shows how the fund performance in comparison to benchmark). Now we will figure out how each fund performed in asset allocation, security selection, and Interaction of both of them.
Step 3: To calculate Overweight:
Overweight= (Weightage allocated by fund manager to a sector)-(Benchmark weightage for that particular Sector)
Step 4: To calculate Performance:
Performance = (Returns earned on fund’s portfolio) – (Returns on Benchmark for that particular sector)
Step 4: To Calculate Asset Allocation effect:
Asset Allocation effect= (Benchmark return for each sector * Overweight value by the fund for that sector)
Step 5: To Calculate Security Selection effect:
Security Selection effect= (Benchmark Weight) * (Performance (Difference))
Step 6: To Calculate Interaction effect:
Interaction effect = (Overweight * Performance)
Step 7 : To Calculate ɑ:
α (Fund Manager’s Performance) =Sum of (Asset Allocation + Security Selection + Interaction)
(* represents multiplication of both of the entity)
If the portfolio outperforms and outweighs the benchmark, the interaction effect will be positive. But here we have all the interaction effects negative. Here we can see the fund’s returns outperformed mostly because of security selection. We can interpret that the fund manager uses a bottom-up approach to manage funds.
Various mutual fund schemes are focused upon only one asset class and it can be even more specific by investing only in one sector in that asset class. For example, SBI Healthcare Opportunities fund Growth focuses on the healthcare sector. Such mutual funds will have high risks and high reward ratio because it is not diversified into different sectors. Also, there are examples where the whole fund is based on commodities and it will also have a high risk-reward ratio
Invest in the right asset class because investments with the help of compounding can do wonders. Even the small difference in returns can lead to a big difference in the long term, so evaluate your investments at a certain interval of time according to your investment mindset (If you are a long-term investor it shouldn’t bother you much) and your risk appetite.