Investing in Active Mutual Funds

Dated 01/07/2021

Hello Dear Reader.

First and foremost, I would like to thank you for subscribing to the premium newsletter. I will try to deliver content which is worth every penny you have put into this subscription, be it a monthly or an annual subscription.

You might be confused by the topic of today’s newsletter. I will like to make a disclosure here to all my readers. Though I am a passive investor myself, I am not a hardcore passive investor. I never try to hide this fact.

For this reason, today we will look at evaluating mutual funds.

Let us ask ourselves,

How does one go about evaluating a good mutual fund scheme from a bad mutual fund scheme?

We will here talk about four things:

• The Treynor ratio

• The Sharpe ratio

• The Jensen's measure, or Jensen's alpha

• Beta

The Treynor ratio, also known as the reward-to-volatility ratio, is a performance metric for determining how much excess return was generated for each unit of risk taken on by the mutual fund scheme. In simple terms, a higher Treynor ratio result means a portfolio is a more suitable investment.

The Sharpe ratio is the average return earned in excess of the risk-free rate per unit of volatility or total risk. It adjusts a portfolio’s past performance—or expected future performance—for the excess risk that was taken by the investor. A higher Sharpe ratio is good when compared to similar portfolios or funds with lower returns.

The Jensen's measure, or Jenson’s alpha is the difference in how much a person’s return is vs. the overall market. Jensen's measure is commonly referred to as alpha. It accounts for the risk-free rate of return for the time period.

Beta is nothing but a measure of the volatility—or systematic risk—of a security or portfolio compared to the market as a whole. For our purposes, we will assume Beta to be of three types:

1. Less Than 1: A beta value that is less than 1.0 means that the security is theoretically less volatile than the market.

2. Greater Than 1: A beta that is greater than 1.0 indicates that the security's price is theoretically more volatile than the market.

3. Less Than 1: A Negative beta means that the stock is inversely correlated to the market benchmark.

Generally, mutual fund schemes with the following attributes are poised to perform well in their category:

• A Lower Beta

• A Higher Sharpe Ratio

• A Higher Treynor’s Ratio

• A Higher Jenson’s Alpha

Ok, so now we have a bird’s eye view of how to evaluate the performance of a mutual fund before investing. But this is not enough. We also need to look at a few other factors.

• The fund’s AUM. I am not a big fan of funds which have a very high AUM and not a fan of funds whose AUM is very low.

• It’s historical returns

• The Benchmark and the fund’s return’s against this benchmark

• Quality of stocks in the portfolio and the churn rate. I am not a big fan of high churn rates when it comes to mutual fund schemes

• The track record of the fund manager, his history with the AMC, managing the fund and his profile

Last but perhaps a very important factor is the expense ratio that an AMC charges you for managing your funds under its scheme and the portfolio turnover ratio. The lower, the better.

Now that we have discussed most of the aspects of how a mutual fund is selected, let us do a an exercise.

Let us take two funds. I will for the purpose of not causing a controversy hide the names of the schemes and the AMCs.

Take a moment to examine the ratios. Let is look at another data point.

Ok. Now you might be getting confused. Let me bring forth another metric.

Now finally, let us look at the annualized return of both the funds since their launch.

Fund A was launched in 2013 and Fund B was launched in 2015. S&PBSE500 was up 42% between May 2013 and March 2015. In the same period, Fund A beat the index and was up 61%.

Now, I am not advocating for this fund. All I am saying is that since the launch of Fund B, the absolute returns of Fund A till date have been 158.64% while that of Fund B have been 134.7%. We will keep in mind that Fund A has a turnover of less than 10% while Fund B has a turnover of over 100%. While we see this, we also see that over the course of this time, the AUM of Fund A has grown significantly as compared to that of Fund B. Personally for me, this is a sign of investor trust in the scheme and in the AMC. We also see than Fund A has a lower Beta and a higher Sharpe ratio, a higher Treynor ratio and a higher Jenson’s alpha. This for me is also a favorable attribute. The only thing that is bothering me about Fund A is its higher expense ratio viz-a-viz Fund B.

Now that we know the above facts, let us ask one critical question to ourselves. Would we prefer to pay a lower expense ratio for Fund B or buy Fund A at a reasonably priced expense ratio?

If you get the answer to this question, you know your mutual funds better than an IFA.

Let us apply the Rule of 72 here and ask ourselves, how much time would it take for us to double our money if the 20.53% annualized returns of Fund A continue for next 12 year? The answer is 3.5 years.

The above scenario is hypothetical based on my assumptions I made in my First and Second newsletter. The purpose was not to give you investment advise but to help you in analyzing mutual funds and running a scenario wherein you can make the most of this knowledge, hypothetically if direct equity investing is too much of a headache for you and you still want to earn more that the index returns.

Rgds,

Ayush Agrawal

For any queries or feedback, do get in touch with me on valueinvestorayush@gmail.com

Disclaimer: The author of this publication is not a SEBI Registered Advisor or Analyst. The information on the company and its promotor mentioned in this newsletter is provided for information purposes only. It does not constitute an offer, recommendation, or any investment advice to any person nor does it constitute any prediction of likely future movements in the company’s stock prices or business performance. It should not be used as a basis for any investment decisions or as a proposition to buy or sell any securities. Please seek advice from a registered financial advisor and do your own due diligence before making any investment decisions.