Performance Evaluation of Mutual Funds

A mutual fund is a type of financial intermediary in the capital market that pools collective investments from retail and corporate investors in the form of units and manages a portfolio of different schemes that invest those collective investments on behalf of the investors in equity and debt instruments. Instead of taking the risk of investing money directly in these assets, a mutual fund is a professional institution that allows an investor to participate in equities and debt securities indirectly. The majority of the time, investors lose money because they choose the wrong equities shares or bonds because they lack the knowledge or competence to invest money directly in the Indian equity market. As a result, mutual funds operate as a middleman, offering active portfolio management skills and risk diversification by distributing assets from all investors over a range of equity shares and debt instruments. In contrast to returns at high risk, if investors invest directly in the capital market, this allows investors to achieve good returns at low risk.

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A mutual fund is a pool or reservoir of funds that are managed by a competent and experienced Fund Manager. It is a trust that manages investments in stocks, bonds, money market instruments, and other assets using money from a group of participants who share a common investment objective. By determining a scheme’s “Net Asset Value,” or NAV, after deducting pertinent costs and levies, the income produced by this combined portfolio is allocated equitably among the investors. Simply put, a mutual fund system distributes the money gathered by numerous participants in the form of units. Depending on how well these investments perform, the pooled funds invested in stocks, bonds, or short-term securities may increase or decrease in value. The value of NAV will be affected by this.

Mutual funds are ideal for individuals who either don’t have a lot of money to invest or who don’t have the time or knowledge to do market research but still want to increase their wealth. The fund house receives a little fee in exchange for their professional assistance, which is deducted from the investment. The Securities and Exchange Board of India has set specific limits on the fees that mutual funds may charge (SEBI). Mutual funds have gained favour in recent years as a result of investors consistently investing in equity/balanced schemes through them.

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Advantages of Mutual Funds

AMC (Asset Management Company), a professionally run organisation, manages mutual funds through professional fund managers that actively manage investment portfolios of different mutual fund schemes. This provides investors with the following advantages:

• Portfolio Diversification: A small investor can hold a diversified investment range even if the amount invested is modest because mutual funds invest in a diverse portfolio of financial products.
• Low Risk: Investors can build a diverse portfolio of financial products even with a small investment. When compared to investing directly in just 2 or 3 shares or bonds, the risk in a mutual fund scheme with a diverse portfolio is lower.
• Low Transaction Costs: Mutual funds have lower transaction costs as a result of economies of scale. Investors also benefit from these advantages.
• Liquidity: Units of a mutual fund may be quickly redeemed, with the proceeds being transferred via ECS payment directly to the investor’s account.
• Choice: Mutual funds give investors a selection of plans with various investment goals. Therefore, there are many opportunities for investors to invest in a plan that matches their financial objectives. These programmes also offer a variety of plans and options, such as a dividend option, growth option, reinvestment option, etc.
• Transparency: Funds give investors access to the newest market and investment plan information. Investors are informed of all relevant information per SEBI and AMFI regulations. They offer investors the most recent NAV daily.
• Flexibility: Mutual Funds give investors some flexibility as well. Through the systematic transfer plan option, investors can move their units from a debt scheme to an equity scheme or a balanced scheme (STP). Investors in open-ended schemes also have the choice of systematic withdrawal at predetermined intervals (SWP) or systematic investment through monthly/quarterly instalments (SIP).
• Safety: The mutual fund sector is completely governed by SEBI regulations, which protect investors’ interests. All funds are required to register with SEBI, and strict adherence to the rules and transparency are both guaranteed.
• Professional management: Expert professional managers who have the knowledge and credentials to evaluate the performance and prospects of companies oversee the portfolios of mutual funds. They closely analyse portfolios every day to actively manage them, which is impossible for a retail investor to do.

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History of Mutual Funds in India

A developed economy requires a healthy financial sector with money coming from retail investors. To encourage savings and investments, the Government of India and the RBI spearheaded the creation of the first mutual fund in 1963 through the Unit Trust of India (UTI). Retail investors were given access to a portion of the income, earnings, and gains generated by UTI from the purchase, holding, management, and sale of securities.

• Phase 1: In 1978, UTI was cut off from the RBI, and IDBI took over the regulation and management of the company. UTI’s first programme, US-64, which was also its greatest programme for a while, was introduced.
• Second Phase: The first non-UTI mutual fund was established by SBI in June 1987, followed by Canbank in December 1987, PNB in August 1989, Indian Bank in November 1989, Bank of India in June 1990, and Bank of Baroda Mutual Fund in October 1992.
• Third Phase: The first private sector MF registered in July 1993 was The Former Kothari Pioneer, which has since amalgamated with Franklin Templeton MF. When private sector mutual funds entered the market in 1993, giving Indian investors a wide range of MF products, a new era in the Indian MF business was born.
• Fourth Phase: The Unit Trust of India Act of 1963 was abolished in February 2003, and UTI was split into two distinct organisations, the Specified Undertaking of the Unit Trust of India (SUUTI) and the UTI Mutual Fund, which operates per the SEBI MF Regulations, 1996.
• Fifth Phase: In September 2012, SEBI started several proactive measures to boost the sluggish Indian Mutual Fund industry and increase MFs’ penetration in the remote areas of the nation. This was done in response to the low penetration of MFs, particularly in tier II and tier III cities, and in consideration of the interests of various stakeholders.

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Performance Evaluation of Mutual Funds

Investments in mutual funds require some level of financial and market awareness. Investors have two options here. Either purchase a regular fund from a third party or invest directly after a thorough study. However, it is not where an investor’s obligations end. It would be beneficial if you also monitor the fund’s performance on the market.

• Set Investment Objectives. What does my investment intend to accomplish? Your mutual fund decisions should be based on the response to this. For instance, you can decide to invest in a debt fund if you desire a consistent income with capital protection. Equities, however, will serve your needs if you have a higher risk tolerance and want to increase your money. Therefore, it is essential to establish your financial aim before choosing your investment. This is essential to the evaluation of funds.
• Select a few similar Funds to compare. An evaluation of a mutual fund in isolation is challenging. As a result, you should constantly compile a short list of comparable funds and compare them. Free mutual fund screener tools are provided by a large number of FinTech companies and independent websites.
• View the performance data from the past. Nowadays, a disclaimer indicating that previous performance is no guarantee of future performance can be found in every mutual fund manual. However, you may use this information to see how the fund has performed across several market cycles. The fund manager’s abilities can also be revealed by consistency. In other words, it will be simpler for you to locate a fund with better returns but smaller risks.
• View the Fund’s Fee Plan. You must pay a mutual fund company for its services and knowledge. Some investments call for swift management decisions about whether to buy, sell, or hold onto an asset. Please keep in mind that a higher charge does not necessarily mean a better fund. Before making a decision, be sure to consider other factors.
• Look for Risk-Adjusted Returns. Every fund anticipates particular market and sector risks. Risk-adjusted returns are what we refer to when funding strategies in a way that maximises returns relative to projected risks.
• Performance compared to Index. All fund performances are assessed based on benchmarks established by indices including the Nifty, BSE Sensex, and BSE 200. It can be instructive to compare various timings to the benchmark and peers. During a market downturn, a well-managed fund won’t fall too far.

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Measures to Evaluate a Mutual Fund’s Performance

• An established benchmark is used to assess the performance of mutual funds. A financial ratio known as alpha measures the excess returns produced by a fund above those produced by its benchmark index. If the fund’s Alpha value is 0, it has performed in line with its benchmark. A score below zero indicates the fund underperformed in comparison to its benchmark index, while a value above zero indicates the fund outperformed. It is typically seen as a measurement that depicts the value that a fund manager contributes or takes away from the returns of a portfolio.
• The expense ratio, which represents the per-unit cost of administering a fund, is the ratio of the total fund’s expenses to its assets. The expense ratio is inversely related to the AUM (Asset Under Management) of the fund and is deducted from the overall earnings of the fund before it is given to the investors. It is a crucial feature to take into account when choosing a fund because, in general, the greater the expense ratio, the lower the return will be.
• Another statistical measure indicating the volatility of a portfolio in the market is beta, which is derived using regression analysis. It demonstrates how a portfolio’s return has a propensity to change in response to market changes. A mutual fund with a beta value of 1 is as volatile as its benchmark. A value below 1 denotes that the fund reacts less quickly than its benchmark, while a value above 1 suggests that the fund is more volatile.
• The diversification of the portfolio’s assets is one advantage of investing in mutual funds. Since volatile assets are balanced out with stable ones in a well-diversified portfolio, higher returns are anticipated. You may find information on the allocated assets in the fund’s portfolio in the fund fact sheet.
• Rolling returns are average annual returns for a certain period that take returns into account through the final day of the period. It displays the fund’s relative and absolute performance over time. Because a CAGR only accounts for the fund’s performance at the moment of calculation and not throughout the full year, it might occasionally be a more useful metric than CAGR. As they reflect how the fund fared throughout the full tenure, rolling returns can be more efficient, accurate, and objective.
• Comparing fund performance to the benchmark is always a good idea. The benchmark serves as a yardstick for the performance of the funds. Consistently beating the benchmark is a sign that your fund is performing well. Additionally, you can assess the average return over a given period about peer funds belonging to the same category.
• The Sharpe Ratio demonstrates how much more return you get for taking on more risk. As a general rule, more risks require greater compensation. In addition, you merit compensation (extra returns) for the increased volatility. You may find out the precise amount of the payoff using the Sharpe Ratio.

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Why Track the Investment Performance?

You may have seen the statement that “previous performance does not guarantee future results of a fund.” It implies that you cannot anticipate returns on investment that are assured. As a result, while evaluating a mutual fund, you must consider factors other than past performance. To make wise selections that can result in greater profits, you should first examine your assets. You are aware that changes in the overall state of the economy cause the capital market to fluctuate. The asset allocation of the portfolio is disturbed by such a change. It might raise the fund’s risk profile above and beyond what you need. You can compare the performance of your investment to that of other funds that are similar by using fund assessment. An evaluation may also be prompted by a change in your fund’s core characteristics or fund manager. Therefore, a review and rebalancing may be necessary to maintain the portfolio’s risk profile.

How Often Should Fund Performance be Evaluated?

The market is susceptible to changes. That doesn’t imply you have to evaluate the fund performance every day, though. Depending on the length of the investment, you should ideally examine your fund every six months to a year. The performance of your assets cannot be accurately assessed by evaluating the funds over a shorter time frame. You can invest in conventional funds if all of this sounds too much. They offer you investment advice as qualified intermediaries depending on your risk tolerance and financial objectives.

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You may evaluate the performance of mutual funds using the aforementioned criteria, which will help you choose the best one. You should also evaluate whether the fund’s performance is consistent with your long-term financial objectives. Once you’ve selected the best fund, you must periodically check on its performance to make sure it still fits your goals and risk tolerance. Download the entri app to enhance your knowledge on topics under the stock market.