Finding the best mutual funds is a not straightforward.
It is not as simple as going to a mutual fund ranking portal and noting down the names of 5-star rated funds. That’s not enough!
Let’s firstly see what is the problem with ranking portals and then move on to a solution.
You can have a trailing return for any period. Let’s understand the meaning of trailing return using an example.
Let’s say today is 25th January 2019.
We are going to check the trailing return of SBI Bluechip Fund-Growth for the last 1 year. What exactly do we check in this case?
We compare the NAV’s of SBI Bluechip Fund-Growth as on 26th January 2018 versus the NAV as on 25th January 2018 – a 1-year block.
This comes out to be -8.3%
We can do the same for periods like 3 years and 5 years.
To summarize, the following are returns of SBI Bluechip Fund-Growth for the last 1, 3 and 5 years…
This is akin to saying Virat Kohli scored X, Y and Z runs in the last T20, ODI and test match respectively.
But should Kohli’s batting ability be judged by his final score in the last game in played in all the formats?
Kohli is someone who is known for his consistency.
It’s great that he scored a century in the last test matches but that is not sufficient.
To assess his test match format performance, we probably need to go back 40-50 test matches (more the better). All the scores he made in these Test matches need to be taken into account.
Then and only then shall we be able to say something about Kohli’s consistency.
The problem with ranking portals: They rely on trailing returns of mutual funds to rank them.
The Importance of Rolling Returns
Now, why is it important to go all the way back? Don’t we know about Kohli’s consistency already?
Yes, we do.
But we are not looking to establish the fact that Kohli is consistent. We are looking to establish the fact that among all the batsmen, Kohli is the most consistent.
Let’s say, in the last T20, ODI and test match, Bumrah somehow scored more runs than Kohli. Does that make Bumrah a better batsman than Kohli? Absolutely not!
This means that if a fund A did better than another fund B in the last 1,3,5 years, it is not necessarily a more consistent fund than fund B.
So, the average scores in all three formats over the last many matches will help us establish Kohli’s consistency over Bumrah’s.
This is the reason why mutual funds should be compared using rolling return and not trailing return.
But is rolling return enough?
Standard Deviation: A Measure of Risk
Sticking to our cricket analogy…
Let’s jot down the scores of two imaginary batsmen…
Both the batsmen have scored 500 runs in all. This makes their average scores the same – 50.
However, if we have a quick glance at their individual scores, we find that batsman 2 has been extremely consistent.
Batsman 1 has big scores like 93, 97 and a couple of hundreds too. But all his other scores are absolutely dismal – 0, 3, 4, 15, 13 and 18. This shows lack of consistency.
Batsman 2 doesn’t have any hundreds to his name. But all his scores except one are greater than 35. So, he can be relied up on in every match unlike batsman 1.
Let’s now see what the last row is all about in the table.
Standard deviation of batsman 1’s scores is 55 while that of batsman 2’s scores is 19.
Standard deviation is an indicator of the volatility of the scores.
As we saw, batsman 1 has scores all over the place. So, his standard deviation is high at 55.
Batsman 2 has scores that are mostly close to each other. So, the consistency is higher and standard deviation is way lower at 19.
So, an investor should have a look not only at the rolling returns but also the standard deviation.
Standard Deviation Across Different Equity Funds
Let’s say you are looking to make a choice between two large cap funds.
Your choice of large cap fund should ideally have a higher rolling return along with a lower standard deviation.
Which fund would you choose from among the following large cap funds?
Most investors would choose SBI Bluechip Fund and that’s not wrong!
However, a few investors would select ICICI Prudential Bluechip Fund. This wouldn’t be wrong either. Simply because some people care more about volatility than returns.
To get to the right answer for you, you need to have a good understanding of rolling return and standard deviation to make the right call.
Which fund would you choose from among the following funds?
Did you answer Mirae Asset Emerging Bluechip Fund?
Well, for starters, Mirae Asset Emerging Bluechip Fund is the newest of all the funds listed. It started in 2010. So it has enjoyed the entire bull run that we are in currently.
On the other hand, Franklin India Smaller Companies Fund started in 2006. It faced the entire brunt of 2008 financial crisis.
Nonetheless, the most important point I am looking to make here is…
Don’t compare the standard deviation and rolling returns across different types of equity mutual funds.
For example – Would it be right to compare the batting average of Virat Kohli with that of Ravindra Jadeja? Absolutely not!
Ravindra Jadeja doesn’t get to face as many deliveries as Virat Kohli does. Moreover, he is not a pure batsman like Virat. He is an all-rounder.
But would it be fair to compare the batting average of Virat Kohli with that of Rohit Sharma. Yes!
Because neither is at a great disadvantage and both are pure batsmen.
Similarly, you cannot compare the rolling returns and standard deviation of a large cap fund with that of a small cap fund. In most cases, for the same period, a good large cap fund will have a lower rolling return and standard deviation than a good small cap fund.
So, it is prudent to compare the rolling returns and standard deviation of fund in the same category.
Other factors to consider are – time period of the comparison should be same. As we saw, Mirae Asset Emerging Bluechip Fund, apart from being a great fund, has existed only when we have seen a continued bull run.
Comparing two funds for two different periods is another mistake you should avoid.
The funds need not have started in the same year. You can consider the NAV data for the maximum possible period.
For example – Let’s say large cap fund A started in 2008 and large cap fund B started in 2010. If you wish to compare the performances of these funds, you must consider the performance of fund A from 2010 and of fund B from inception – 2010. Anything else and you are putting one of the funds at an advantage/disadvantage.
Now we are in the perfect position to introduce another important mutual fund parameter – Sharpe ratio. It would be criminal to not do so now.
Developed by William Sharpe, Sharpe ratio is the most accepted metric to measure “risk-adjusted returns.”
The simple idea is to compare the returns of a mutual fund to the risk-free rate of return the market offers. And add a risk parameter to these parameters.
Here’s how Sharpe ratio is defined mathematically…
Rmf is the return of a mutual fund for a period like 1 or 3 years
Rrf is the risk free rate of return (usually the rate of return of 10 year government bond)
Std Dev is the standard deviation of the mutual fund for the considered period
Let us say for Fund A the 3-year rolling return has been 15%. The 10-year government bond has a yield of 5%. Additionally, the standard deviation of 3-year rolling returns of fund A is 8%. The Sharpe ratio will be calculated as follows…
If the Sharpe ratio of fund A is 1.125 and that of fund B is 1.05, which fund is better?
The deeper we go into our quest for the best mutual funds, the more we realize how difficult it is.