Big Story: Factors to Consider While Evaluating Equity Mutual Funds


Mutual funds are amongst the most popularoptions for investors to park their hard-earned money in, for various goals. As of October 2023, there are 1,461 mutual fund schemes. Zeroing in on a particular scheme out of this is a tough task. There are quantitative as well as qualitative factors to consider, apart from the suitability of the fund for our risk appetite as well as needs.

To address the quantitative aspect, we present here certain risk and return-based metrics to help you choose funds that suit you. These metrics are typically found in the fund house’s fact sheet and other secondary sources online as well as in print. Hence, you don’t have to analyse from scratch. Applying these to understand, interpret and compare similar funds  can help you make informed decisions.

Return metrics

The most important and basic aspect we look for in any investment product is its ability to generate returns. There are multiple ways of looking at past returns of a mutual fund.

Absolute return is only concerned with initial investment value and the final investment value and hence shows how much gain/loss one has made on his/her investment. For instance, if you have purchased units in a large-cap fund at ₹59 and sold them at ₹173, then the absolute return comes out at around 191 per cent. However, absolute return doesn’t take time period of investment into consideration and the compounding effect. Hence, though this return looks brilliant, we can’t conclude that the fund has performed well.

Trailing CAGR (Compounded Annual Growth Rate)comes into play when we take the time period into account and look at growth on an annual basis. It is seen as better than absolute return when returns over long period are to be judged. For instance, in the same fund discussed above, an absolute return of 191 per cent seems very attractive but one needs to note that the fund has returned so much during the last 10 years, which implies a CAGR of just 11 per cent.

In view of this, the fund is amongst the worst performing ones in the large-cap category and has underperformed benchmark S&P BSE 100 TRI by nearly 3 percentage points on a CAGR basis over the last 10 years. That said, while trailing CAGR is better than absolute return, it is not flawless either.

For instance, consider these two flexi-cap funds, Fund X and Fund Y, which have generated five-year CAGR returns of around 23 per cent and 18 per cent respectively. Going by just five-year CAGR returns, it appears that Fund X has been performing better. Is it really the better one?

Rolling return CAGR can help us do further analysis. While trailing CAGR returns rely on a specific start and end date, rolling returns capture the returns of a mutual fund between multiple starts and end-dates. It helps us get a series of CAGR returns over a long period of time. For instance, five-year rolling return CAGR (rolled on a monthly basis) of a fund over a 10-year period can provide you with mutliple five CAGR returns — such as returns from November 2013 to November 2018, December 2013 to December 2018, January 2014 to January 2019 and so on till November 2018 to November 2023. Likewise, there are many options here such as one, three or five-year CAGR rolled over daily, monthly or yearly over a period of time. Ultimately, the idea behind using a rolling return metric is to check for consistency of returns.

So, if we consider the same Fund X and  Fund Y and take a 10-year period and compare monthly rolled five-year CAGR returns over this period, we can have better clarity on which fund is a more consistent performer. Going by rolling returns ranging 10-15 per cent, Fund X has seen such returns 15 per cent of the time during last 10 years (2013-2023) against 4 per cent of the time for that of Fund Y. But if returns more than 15 per cent are considered, Fund Y has much higher consistency in generating the same than Fund X.

Systematic Investment Plans (SIPs) are opted for by most investors. Here, you put in a sum at regular intervals in one or more funds. Each SIP instalment remains invested for a different period of time. This is where the XIRR (Extended Internal Rate of Return) is the solution. This metric gives you an annualised return based on all the investments and withdrawals done during different time periods.

The returns calculated in this manner for SIP can differ from CAGR returns achieved by lumpsum investments.For instance, if you made a lumpsum investment in a regular plan of a popular small cap fund three years back, you would have achieved CAGR returns of 27 per cent. However, if you have been making investments in the fund through monthly SIP, you would have earned annualised return (calculated through XIRR) of around 22 per cent — lower than that earned through lumpsum investment.

Risk metrics

Return is definitely among the most important factors to consider while investing but do note that higher returns come with higher risk. Hence, along with return, one must assess risk metrics too. he degree of risk may not be similar for all mutual funds and this can be measured using certain risk metrics.

Standard deviation (SD) measures the degree of variation of returns of a mutual fund from its average annualised return over a period of time . Then there is beta which provides us with the sensitivity of a mutual fund relative to its benchmark. However, these metrics have certain limitations and can’t be looked at in isolation.Hence, risk-adjusted measures come into play.

Sharpe Ratio is one such metric. It measures the excess return on every additional unit of risk taken. Hence, the higher the Sharpe ratio, the better it is for the fund. This can be calculated by dividing the excess return a fund has generated (over risk-free rate of return) by the fund’s SD. Typically in factsheets, you can see Sharpe ratio calculated using monthly rolling returns for three-year period with risk free return considered as overnight MIBOR rate.

Considering small-cap funds C and D, Fund C has a three year return CAGR of 42 per cent against 46 per cent for Fund D. However Fund C’s Sharpe ratio is at 0.57 and higher than that of Fund D’s at 0.50. This means that despite generating lower  returns, Fund C’s risk-adjusted returns are higher. However, Sharpe ratio considers both downside and upside volatility while investors care more about the downside part. .

Sortino ratio comes to the rescue here as it punishes the fund only for downside volatility rather than the overall volatility. The calculation for Sortino ratio remains the same as Sharpe ratio except that downside volatility is considered here rather than overall number. It indicates how much return a fund is able to generate in excess of risk-free return, adjusted for downside volatility. Higher the sortino ratio, better it is for the fund.

For instance, while small-cap Fund E generates Sharpe ratio similar to that of Fund F, Fund E’s Sortino ratio (1.22) is higher than that of Fund F (1.04). This indicates that Fund E generates higher downside risk adjusted returns despite having same Sharpe ratio.

Downside capture is also a useful metric. tIt indicates the performance of a mutual fund against that of benchmark when markets are down. A mutual fund with downside capture ratio of less than 100 is seen to have performed better than the index during bearish phase. For instance, Fund E discussed above has downside capture of 54 which means that during down markets, the fund has made only 54 per cent of the losses suffered by the benchmark.

Do note, these quantitative metrics are based on the historical performance of the funds and hence don’t reflect future performance. Also, any of these metrics should not be seen in isolation and one can compare the statistical measures of the fund with that of peers, the benchmark and category average.             

Other metrics

Portfolio turnover indicates the frequency of changes i.e. buying and selling of assets in the fund manager’s portfolio over a period of time (usually one year). For instance, small-cap funds M and N have turnover of 17 per cent and 140 per cent respectively. It means that, for Fund M, 17 per cent of the portfolio holdings have been changed over the last one year while for Fund M the whole portfolio has been changed more than once during the period.

While there is no proven evidence of any correlation between portfolio turnover and returns, there is the perception that high portfolio turnover can sometimes lead to higher expenses relating to frequent buying and selling of stocks. On the other hand, a low turnover may indicate a ‘buy and hold’ strategy.

Expense ratio is the fee you pay the fund house to manage your investments, collectively termed Total Expense Ratio (TER). The daily NAV (net asset value) of mutual fund is disclosed after deducting expenses.  Generally, lower TER appears better as it can provide higher net return to investors. However, the investment decision should not be based solely on TER.

Metrics for passive funds

The return expectation while investing in passive funds is quite different from that of investing in actively managed mutual funds. To invest in a passive fund, one needs to decide on a particular index and check how closely the fund is tracking the index and to what extent it is able to replicate its performance. The returns generated by the fund and that of benchmark index will always be different on account of reasons such as administrative and management expenses, cash balance (in case of index funds), rebalancing and liquidity issues. The variability in the returns of a passive fund from that of underlying index can be measured by tracking difference and tracking error.

Tracking difference is the absolute difference between the returns of a passive mutual fund and its underlying benchmark index over a period of time, which can be a month, a year, etc. For instance, benchmark index Nifty 50 gained 5.15 per cent during the last month while index Fund G, which tracks Nifty 50 index, generated return of 4.26 per cent, which implies tracking difference of 0.89 per cent.

However, do note that tracking difference tells you only about the difference in return during a period while tracking error indicates how consistently the fund’s performance deviates from index it attempts to replicate. Hence, tracking error is basically the annualised standard deviation/volatility of the tracking difference for a particular time period. Lower the tracking error for a passive fund, better it is. For instance, one-year tracking error rolled over daily basis (as typically mentioned in fact sheets) for two Nifty 50 based ETFs Fund H and Fund I are 0.04 per cent and 0.03 per cent respectively. This indicates that Fund I replicates the performance of the benchmark better than Fund H.

Investors can typically find tracking error details in the mutual fund factsheet. Last year, SEBI came out with a circular on passive funds with a host of regulations for passive funds, aimed at improving the liquidity, tracking error limits and certain disclosure requirements. In the circular, SEBI mandated fund houses to disclose past one-year tracking error data on rolling basis on their respective websites and AMFI. Also, limits were put in place. For instance, tracking error over last one year should not be more than 2 per cent now.

For ETFs which are traded in the market like stocks, investors also need to note the market price vs the iNAV (Indicative NAV) of the fund.

SEBI has mandated fund houses to disclose iNAV for its equity ETFs within a maximum time lag of 15 seconds from the market. Investors can compare the actual price at which ETF is trading and its iNAV. There can be differences between these two numbers because of issues such as liquidity associated with the ETF. The ETF where the difference is the least can  be preferred.


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