Mutual funds can confound us with their variety and objectives. There are a plenty of mutual funds which can fit all hues of risk and reward combination. While the varieties offer more options to choose from, the same varieties can confuse investors if they do not know how to understand them. Understanding the proportion of equity, objectives, and your own goal and investment horizon are very important to make the most of the fund.
Since most of the retail investors do not have time and expertise to understand the stocks and businesses behind them, they find a responsible advisor in fund manager. Mutual funds diversify the investment into various equities and bonds and thus reduce the risk entailed in the case of individual stocks. Though diversification reduces returns it reduces risk, which is an important parameter from a retail investor’s perspective.
In this article, we will focus on the important ratios concerning mutual funds (note, many of these will also apply to Exchange Traded Funds).
Ratios for mutual funds
Just like stocks, mutual funds have their own ratios that the investors need to look at to judge the investment worthiness of a fund. These ratios will help retail investors understand some of the key factors that impact their returns from mutual funds.
Expense ratio is the cost incurred in running the fund by the investment fund house. The expense ratio is calculated by dividing the operating expense by Total Net Asset Value of mutual fund. It is given in %. The figure is also expressed in bps, which is a multiplication by 100 of percentage figure. The expense ratio is a very important parameter as the expenses are taken from the returns and hence it lowers the returns that the fund earns. A point to be noted here is that a fund takes out this amount regardless of the profit margins i.e. even when the fund runs in losses.
Expense ratio is usually less for index funds since the fund manager doesn’t need to do more research, but just needs to track a market index.
So once you have shortlisted a sector and a few funds in that sector choose a fund which has least expense ratio for investment.
The entry load is the initial charges taken out by the fund from your investment. Hence when you buy the mutual fund, you don’t get fund units worth full value of your money. The exit load is when you sell fund units you have to pay the exit load.
As the definition specifies, it’s better to choose lower load funds.
Portfolio PE ratio
The PE ratio of mutual fund is price by earnings ratio. It simply tells you how much you are paying to earn Rs 1. If the PE ratio is 25, you are paying Rs 25 to earn Rs 1, a 4% return. This is certainly making things too simplistic as the earnings will keep growing for the companies which are part of the mutual fund. There is no hard and fast rule but a PE ratio of 20 and less is preferable. The other side is that a high PE ratio indicates that people are ready to pay higher price for the fund because the market believes that the fund value can grow faster.
Portfolio PB Ratio
The PB ratio of a mutual fund is aggregated price to book ratio of all the stocks and entities comprising the fund. The PB ratio tells you the price you are paying for a unit book value. The book value is another topic which can take many pages. Suffice it to say that book value is nothing but the value of all the assets minus the liabilities. There is no specific value which can be used to measure attractiveness of a mutual fund.
Dividend yield is the dividend distributed by the mutual fund as % of the current market price of the fund. For example, a dividend yield of 3% and more will be great offer in Indian market as Indian companies usually do not give good dividends. The reason is not difficult to guess. India is a growing economy and most of the firms are growing faster. The companies need money to fuel the growth and hence most of the companies invest the earnings in growing the company than distributing it as dividends.
The market cap shows whether the fund has invested in large cap, medium cap, or small cap. The very large market cap shows that the fund has invested in blue chip companies with very large market capitalization.
Market cap helps investors realize the risks and rewards that they should expect from the fund. A large market cap fund that invests in blue chip companies will give average returns with very less risk.
Beta of the fund shows the measurement of risk of mutual fund with respect to the market. In simple language, it tells you how much a mutual fund’s NAV will move for a certain move of the market index.
If a mutual fund has a beta of 1.2, it means it will move 1.2 times the market’s move. So if the market moves up by 10%, the mutual fund’s value will move up by 12%. If the market goes down by 20%, the mutual fund’s value will go down by 20*1.2 = 24%.
A beta of -1.2 means that the mutual fund and market move in opposite direction with mutual fund moving more. For example, if market moves up by 10%, the mutual fund’s value will move down by 12%.
Nobel laureate, Bill Sharpe, devised a formula known as Sharpe Ratio. This ratio measures the returns with respect to risk taken by the fund. The formula is return of fund in excess of the risk free return divided by the standard deviation of its returns.
Sharpe ratio = (Return of the fund – risk free return) / standard deviation of the return of the fund
A higher Sharpe ratio is preferable as it denotes higher returns for the risk taken. A negative Sharpe ratio indicates that the fund is performing worse than a riskless asset.
Standard deviation of a fund is measure of its volatility. A high volatility shows the risk is high. However, as we have just shown above Sharpe ratio is a better measure than just looking at standard deviation in isolation.
The last words
These ratios are very important for investors to know. Most of the mutual funds scheme document will provide the ratios anyway so investors do not have to calculate them. Look at the ratios and decide for yourself. In the end, these ratios will drive the performance of the fund.