In the previous blog, we discussed how to pick the best index/passive mutual fund. And as promised, in this blog, we will discuss how to choose the best active mutual fund.
Estimated read time: 4 minutes and 7 seconds
Buckle up, here we go!
In passive or index funds, we never looked for returns or risk factors because they are just trying to copy the market benchmark and not trying to outperform them.
But in active mutual funds, the managers try to outperform the market benchmark. They do so by actively managing the fund. And this adds extra risk. There are chances of outperforming and underperforming, so we need to look at various risk and return factors while comparing active mutual funds.
Important metrics in active mutual funds
A quick explanation of active funds, these funds try to outperform the index benchmarks like Nifty 50, Sensex 30, Nifty Bank, etc. Managers manage funds actively and buy/sell based on market conditions.
Active funds have a higher expense ratio compared to passive funds. And as explained in this blog, most active funds have failed to outperform the passive funds in the large-cap category in the long term. But in the mid & small-cap categories, many active funds have performed better than passive funds.
And if you have decided to invest in active funds, you need to look for –
I know many would start by looking at the returns of a fund. But I would want you to look for the R-squared metric first to determine whether a particular fund is better than a passive/index fund.
R-Squared compares the performance of the active mutual fund with the benchmark index. It helps to determine how identical the mutual fund’s performance is to a benchmark index.
If the R-Squared of an active mutual fund is above 90%, you can avoid it as you are better served with passive or index funds with a lower expense ratio and risk.
2. Returns – Rolling returns
Experts always say that past performance is not an indicator of future performance, but we don’t have any other way. Only by looking at the past, we can analyse how the fund’s performance was.
Look for the rolling returns of the mutual fund on a 3, 5 and 10-year basis. Compare the rolling returns with its benchmark rolling returns. Rolling returns is the better version of CAGR to analyse the long-term performance of mutual funds. To know more about this, check out this video.
Beta measures the relative risk of the fund compared to its benchmark. Beta is expressed as a number.
If the mutual fund has a beta of 1, then the fund is as risky as its benchmark index. For example, if the benchmark falls by 1%, we expect the fund to fall by 1%.
If the mutual fund has a beta of less than 1, then the fund is less risky compared to its benchmark. If the beta is 0.8, then if the benchmark index falls by 1%, we expect the mutual fund to fall by 0.8% only.
Higher the beta, the higher the relative risk. So, check for an active mutual fund with a lower beta.
4. Standard deviation
The standard deviation measures the riskiness of the fund. As we know, ups and downs are part of the market, and SD helps us to understand the volatility of a mutual fund. The higher the SD, the higher the volatility of the fund.
Try to find an active fund with a lower standard deviation and has some alpha.
Alpha is the excess return an active mutual fund has generated. It helps us to know whether the active fund has outperformed the benchmark returns or not.
As you know, active funds have extra risk. So the calculation of alpha also considers the beta of the fund. Alpha is the excess return over and above the benchmark return on a risk-adjusted basis.
Higher the alpha, the better the fund.
6. Sharpe ratio
Managers of active funds take an additional risk so that they can outperform the benchmark index. But does the additional risk always result in better returns?
Sharpe ratio helps us to check the return earned for every unit of risk undertaken. Higher the Sharpe ratio, the better the fund.
Let’s say, we have two funds, A and B. Fund A gave 14% returns with a standard deviation of 28%. Fund B gave 16% returns with an SD of 18%.
By this, we find out that the Sharpe ratio of fund A is 0.29 and fund B is 0.56.
As fund B generated better returns with low risk, it is a better fund than fund A, and the higher Sharpe ratio proves that.
7. Sortino ratio
The Sortino ratio is like the Sharpe ratio. The only difference is that the Sortino ratio only tracks the downside volatility of the fund. This makes the Sortino ratio the better version of the Sharpe ratio.
The aim of Sortino’s ratio is to estimate the excess return adjusted for only the downside risk. As again, the higher the Sortino ratio, the better the fund.
Important points to remember
- Check the basics of a fund like investment style, the risk associated with it, the manager, AUM, its track record, etc.
- Check for long-term returns of the mutual fund on a 3, 5 and 10-year basis.
- If there is excess return/alpha, check the return is generated at the cost of how much additional risk.
- Don’t take any decision based on a single metric. Compare and analyse all the metrics together.
- Compare apple to apple and not apple to an orange. Don’t compare a large-cap fund with a mid-cap or small-cap index.
- Don’t fall for low NAV or unit price. Lower NAV doesn’t guarantee higher returns possibility.
- You can also invest in mutual funds directly with AMCs without a Demat account.
- Additional risk doesn’t always generate additional returns.
- Don’t forget to harvest tax from long-term gains in equity investments.
Share it with your buddies.
If you are like us, who likes to analyse a little more or check out content in different formats, well you are in luck. Below you can find some suitable content we found.
Note: We don’t have any affiliation with them. We are sharing links only for educational purposes. The opinions expressed by them belong solely to them and do not reflect the views of Vrid.