How to Evaluate the Performance of a Mutual Fund?

It's not enough just to select a mutual fund that has provided the highest return in the past, since a fund might have delivered good returns in one year only to perform badly the next. So how can you tell if your mutual fund is really performing well?

To assess a mutual fund, you have to go beyond its stated return. You need to consider how consistently it has performed, the amount of risk it has taken, how it stacks up against other similar funds, and whether it is aiding you in reaching your financial objectives.

This article explains some simple and practical ways to evaluate the performance of a mutual fund.

Key Takeaways

• Don't judge a mutual fund by one year's return. Look at performance over multiple periods.
• Compare like with like. Use both the fund's benchmark and similar funds as reference points.
• Returns and risk should be evaluated together. Higher returns are not always better if they come with much higher risk.
• Consistency matters. A fund that performs reasonably well across market cycles can be more useful than a fund with occasional spectacular returns.
• Your goals matter most. Choose and evaluate a fund based on your investment horizon, financial goals, and risk tolerance.

Look at the Fund's Returns

The first parameter that any investor checks is the returns. Return is indicative of the gains an investment makes over a certain period. Do not limit yourself to just the one-year return of a fund. Look into the performance of the fund for different periods – 1 year, 3 years, 5 years, and inception onwards.

For instance, let us take an example where a mutual fund has made:

• 1-year return: 8%
• 3-year annualised return: 12%
• 5-year annualised return: 11%

This is more informative than just the 1-year return of the fund. For long-term investments, annualised returns become all the more important because they give the average annual returns over the period.

Compare the Fund With its Benchmark

All mutual funds have a benchmark representing the kind of market or security in which they invest.

An equity fund could be compared with a stock market index appropriate for such a fund. If the performance of the fund was 14% while the benchmark performance was 11%, then it means that the fund performed well against its benchmark.

However, if the performance of the fund was 9% while the benchmark performance was 12%, you might want to find out why. It is important to note that a mutual fund does not have to outperform its benchmark every year because markets experience different stages.

Check Consistency of Performance

High rates of return can be tempting, but consistency can be more critical. Let us assume that we have two investment funds:

• Fund A gives 18%, 19%, 17%, 16%, and 18%
• Fund B gives 35%, 5%, 28%, -10%, and 20%

Even though Fund B may seem appealing in some years, it will certainly be inconsistent compared to Fund A. It should not necessarily be at the top of the fund category. It should be able to perform reasonably well in all types of market situations. It might be easier to invest in such a fund for a long time.

Understand the Risk Taken to Earn Returns

Two funds may make the same amount of returns at the expense of totally different levels of risk. This is the reason why returns have to be analysed in relation to risk. There are several metrics often used, including standard deviation, Sharpe Ratio, beta, and maximum drawdown. You do not need to understand all about these figures. It is important to know the basics:

• Standard deviation shows how the fund's returns vary.
• Sharpe Ratio can help determine if the return generated was justified in light of the risk involved.
• Beta shows the degree to which a fund may be influenced by the changes in its benchmark.

Two funds that produce similar returns but involve different risks may be evaluated against each other.

Check the Expense Ratio and Exit Load

Mutual funds charge specific fees to cover the costs of managing, operating, and administering the scheme. Understanding these total costs is critical, as every rupee spent on fees directly reduces your net returns.

Expense Ratio: The expense ratio represents the annual percentage of the fund’s assets used to cover operational costs. At first glance, a small difference in expenses (say, 0.5% versus 1.2%) may not seem significant. However, over a long period, even a small difference can substantially impact your overall wealth creation because those deducted funds are no longer available to compound.

Exit Load: An exit load is a fee charged by the fund house if you redeem or switch your mutual fund units before a specified timeframe (for example, withdrawing within 1 year of investment). Exit loads are designed to discourage short-term trading in long-term funds. Before investing, check whether the fund imposes an exit load and ensure the lock-in or fee-free period aligns with your planned investment horizon.

Look at the Fund Manager and Investment Strategy

The performance of a mutual fund is affected by the investment strategy it follows and the individuals who manage the portfolio.

See if the fund adheres to a well-defined investment strategy, and also consider the fund manager's experience, as well as whether there have been a number of changes in the management team.

The fact that the fund manager changes doesn't mean that the fund will perform badly, but substantial changes in the way the fund is managed can have an effect on its future performance.

If you want to know the reason why a fund invests in a particular way, this will enable you to decide whether or not it agrees with your own investment approach.

Conclusion

Evaluating the performance of a mutual fund does not mean looking at returns alone. A good evaluation involves checking long-term performance, comparing the fund with its benchmark and peers, understanding the risks involved, and considering expenses and portfolio quality. Most importantly, a fund should match your financial goals and investment horizon.

Instead of chasing funds that performed exceptionally well in the recent past, focus on consistency and whether the fund continues to meet your expectations over time. A thoughtful and regular review can help you make better investment decisions and stay focused on your long-term financial goals.