Important mutual fund metrics when picking mutual funds

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As usual, let me start with another story. When I was in school, I had a bunch of friends who would get hyper-competitive just around the exams. Their aim was not just to score well in the exam but also to score better than some of their friends. I still remember this incident very clearly. The results of the physics paper were out, and it was a super difficult paper to crack. While the rest of the class hoped they would clear the paper, there were these two guys who had scored amazingly well. One of them was my friend. My friend had scored 93, far better than the rest of the class. But there was this other guy who had scored 95. This friend of mine was just not happy. For him, the benchmark was not the rest of the class but this other guy who had scored 95. Benchmarking, in a sense, is very good; it pushes you to perform better.

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Benchmark

Mutual fund schemes are also benchmarked. The benchmark is selected in such a way that it makes sense. For example, a large-cap mutual fund is benchmarked against Nifty 50, which is basically a large-cap index. It does not make sense to benchmark a large-cap fund with a small-cap index. So, when you evaluate a mutual fund, one of the most basic checks is to see how the mutual fund has performed relative to the benchmark. But that said, more than checking the mutual fund's performance against its benchmark, what's more important is managing your own expectations. If you've invested in a large-cap fund, expect large-cap kind of returns. Do not expect small-cap fund returns.

Beta

Next up is the beta of a mutual fund. The beta of a mutual fund measures the relative risk of the mutual fund with respect to its benchmark. Here is the beta of the Tata Multi-Cap Fund. As you can see, the Tata Multi-Cap Fund is benchmarked against the S&P BSE 500. The beta of this fund is 0.95. If the beta is less than 1, then it's expected that the fund is less risky compared to its benchmark. If it is equal to 1, the fund is as risky as the benchmark. If the beta is higher than 1, then the fund is expected to be far riskier than the benchmark itself. One super important thing to remember when you're looking at beta is that beta gives you the relative risk of the fund with respect to its benchmark, but it does not tell you anything about the inherent risk of the fund itself.

To put this in context, we all understand that a Ferrari is much faster than probably a Maruti. This comparison is like evaluating the beta. All it tells us is that the Ferrari is faster than the Maruti, but it does not tell me anything about how fast the Ferrari is traveling or how fast the Maruti car is traveling.

Alpha

Let's discuss the next metric, the alpha. Most people tend to think that the alpha is a measure of outperformance of the fund with respect to its benchmark. For instance, if the benchmark has delivered 7%, and for the same time period the mutual fund has delivered 10%, then the alpha is perceived as 3%. While this is broadly true, in the context of mutual funds, alpha is slightly different. Alpha in the context of mutual funds measures the excess return over the benchmark but on a risk-adjusted basis. So we basically need to evaluate the outperformance of the mutual fund with respect to its benchmark by considering a risk-free rate. And for the risk-free rate, you can always check the yield on a one-year treasury bill.

Given this, here is the formula to calculate the alpha for a mutual fund. Assume a certain fund has given you a return of 10%, and its benchmark returns for the same duration is 7%. The beta of this fund is 0.75. How much do you think is the alpha, assuming the risk-free rate is 4%? Well, if you apply the formula of alpha, you will get the alpha as 3.75%. Needless to say, the higher the alpha, the better it is.

Standard Deviation

The next mutual fund metric that I want to touch upon is the standard deviation. The standard deviation of a mutual fund gives you a sense of how risky the mutual fund is. The standard deviation is a percentage expressed on an annualized basis. The higher the standard deviation, the higher is the volatility, and the higher is the risk.

 Sharpe Ratio

Next up is the Sharpe ratio of a fund. The Sharpe ratio is one of the most sacred formulas in finance. It was invented in the year 1966 by an American economist called William F. Sharpe. William Sharpe even won the Nobel Prize in 1990 for his work on the Capital Asset Pricing Model.

Assume there are two large-cap funds: Fund A and Fund B. Here is how they've performed in terms of returns. Which of these two funds do you think has performed better? Well, it's a no-brainer. Fund B has delivered higher returns, therefore Fund B is a better choice here. Now, let's add some more information. Along with the returns of the fund, I've also included the risk or the standard deviation of the fund and also a certain risk-free rate. Now, given all this information, which of the two funds do you think is better?

Well, if you were to evaluate the fund based on risk, then Fund A is better as it has a lower standard deviation compared to Fund B. And if you were to evaluate the fund based on returns, then Fund B is better as it has delivered higher returns than Fund A. But in reality, you will have to choose a fund based on both risk and return. You cannot isolate risk and return when evaluating a fund. This is where the Sharpe ratio helps us. The Sharpe ratio of a fund is the excess return of the fund over the risk-free rate divided by the standard deviation of the fund.

If you apply the Sharpe ratio formula to Fund A, you'll get the Sharpe ratio as 0.29. What this number conveys is that for every unit of risk, the return is 0.29 over and above the risk-free rate. By this measure, the higher the Sharpe ratio, the better it is, as we all want higher returns for every unit of risk.

Let's apply the Sharpe ratio to Fund B. As you can see, Fund B also has a Sharpe ratio of 0.29, so it turns out both funds are similar in terms of Sharpe ratios. There’s no real advantage in choosing Fund A over Fund B. Now, let's change the standard deviation of Fund B from 34% to 18% and reapply the Sharpe ratio formula. As you can see, the Sharpe ratio is now bumped up to 0.56. What this means is that for every unit of risk that the fund takes, the return is 0.56 higher than the risk-free rate, which obviously is very good.

Do note, the Sharpe ratio only considers price-based risk. It does not consider credit risk, default risk, or other risks applicable to a debt fund, which implies that you should use the Sharpe ratio only for an equity fund and not for a debt fund.

Capture Ratio

Let's move ahead and discuss the last metric: the capture ratios. A benchmark, as you know, is market-linked. Any market-linked instrument will have both positive and negative returns. The capture ratio tells us, for a given period, to what extent the fund captured the positive returns of the benchmark and also to what extent it captured the negative returns of the benchmark.

Here is an example. These are the capture ratios of HDFC Top 100 Fund (Direct Growth). These capture ratios are on a three-year basis, and I've taken this from Morningstar India's website. The fund has an upside capture ratio of 99. This implies that the fund has managed to capture 99% of the index's up-move. The downside capture ratio is 119. This implies that the fund has captured 119% of the downside returns of the index.

The upside capture ratio conveys the extent to which the fund captures all the positive returns of the benchmark. The downside capture ratio indicates the extent to which the fund captures—or rather, avoids—all the negative returns of its benchmark. Given this, ask yourself, what should be the ideal capture ratio of a mutual fund? Well, you would want a mutual fund that would capture 100% of the up-move, if not more, and you would want the downside capture ratio to be minimal.

However, this is not easy. A fund will either have a great upside capture ratio or a great downside capture ratio, but not both. Personally, I like funds that manage risk better, and I evaluate this by looking at the consistency of the downside capture ratio across multiple years.

Anyway, metrics like benchmarking, beta, alpha, standard deviation, Sharpe ratio, and capture ratio are some of the most basic metrics that you will need to know as a DIY mutual fund investor. In the next video, we'll use all these metrics to analyze an equity mutual fund. Do comment and let me know if you have any queries. I'll see you guys soon!