RETURNS yielded by your investments in mutual funds are very important. However, knowledge about how to read and interpret that data is more important, because future decisions may be based on these numbers and if you read something other than what it is supposed to convey, it may influence your decisions in the wrong way.
Let us make a beginning in deciphering mutual fund returns.
Annualisation: Normally, returns from equity-oriented mutual funds are expressed as absolute numbers. The volatility in equity markets are higher than in debt markets and the degree of certainty of similar returns being earned over the rest of the year is lower, hence it would not be correct to annualise it.
For example, if an equity fund has yielded three per cent over three months, simple annualisation implies 12 per cent, but returns over the next nine months may be much higher or much lower so as to make the returns over the entire year something very different from 12 per cent.
In case of fixed income/debt-oriented funds, returns are expressed as annu alised. While there may be volatility in the balance part of the year, it would be lower than the volatility in the equity market.
Mode of annualisation: In liquid/debt funds, returns are expressed as annualised. Annualisation may be simple or compounded.
As a matter of rule, returns less than one year are simple annualised and for more than one year, it is compound annualised.
To give an example, if a debt fund has given five per cent return over six months, it would be expressed as 10 per cent. If it were compound annualised (it is not, just for the sake of awareness) it would have been expressed as 10.25 per cent. If you are not aware that the return of 10 per cent is annualised, you would perceive that it has given absolute 10 per cent over six months. If a debt fund has given 30 per cent return over three years (a period more than one year), since it is compound annualised, it is not expressed as 10 per cent per year, but as 9.14 per cent per year.
Technically, it is called CAGR.
Volatility of returns: There is a concept called `risk adjusted returns' it means a fund has performed well not only if it has given higher returns, but also if the volatility of returns over the period were lower as well. A fund with a lower volatility is said to have performed better than a fund with higher volatility. The expression for risk-adjusted ratio is through the sharpe ratio, which is the return over the period minus he risk free rate of return, divided by the standard deviation of returns over the period.
For example, let us assume the risk free rate as seven per cent (yield on one-year treasury bill), the return over the period as 12 per cent and the standard deviation of returns over the period as 0.3. Then the sharpe ratio is (12-7)/0.3= 0.167. If another fund has given 10 per cent return over the period with a standard deviation of 0.15, its sharpe ratio is (107)/0.15 = 0.2, hence it has performed better than the previous fund.
Outperforming the benchmark: A fund is supposed to have performed well, if it has given returns higher than the benchmark, because the investor had the choice of investing in the benchmark -there should be some reason to invest in this particular fund. This is expressed through the `alpha'.
It is measured as: Jensen's Alpha = portfolio return [risk free rate + portfolio beta * (market return risk free rate)]. Portfolio beta means the extent to which it follows market returns.
The investor may not have the data to calculate sharpe ratio or alpha for himself, but the number as such may be published by the AMC in the factsheet. With awareness of the various measures to calculate risk-adjusted returns, he would be better placed to understand the implications. A simple search on the internet would reveal the definition of any term in the AMC literature which is not known to the investor.
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