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Dos and don’ts of equity fund evaluation

Many like to analyse the constituent stocks and their movement in the portfolio of the fund. This is not essential to do and the above measures are sufficient to understand the characteristics of portfolio performance

Understanding which equity fund is right for you is easy, if you ask the right questions. It is all about understanding the temperament of the manager who is managing the fund. Since the amount of quantitative information available for each fund is quite large, one needs to be careful in separating the signal from the noise.

Let me begin with the task of evaluating the past performance of the fund. Most experiences with this endeavour are best summarised as ‘great until I made the investment’.

The reason for the generally poor investment experience, when using past performance as a guide, is because the right question is not being asked.

The question should be, “What was the performance of the fund at the beginning of the evaluation period?" Unless the initial conditions impacting the investment are exactly the same, the end results will not be. If one has to understand the genes of an Olympic athlete, it is more important to study the athlete’s parent’s genetic material, rather than the individual’s.

Next, let us look at how to evaluate performance itself. What is the right period to look at? The consensus here is to look at the ‘long term’, typically an odd number (for reasons unknown) of years. But that is like using visible light to look at an atom.

Since the wavelength of visible light is higher than atomic dimensions, one will not be able to discern anything. The way to do it would be to take a smaller period, say, monthly returns, over a long evaluation period. As an example, if you are working with the last 10 years of performance data, then use 120 monthly returns as the starting data set.

Then take the top and bottom few months of best and worst returns. Compare the returns with the corresponding period index performance. That should give you better insight into how the fund performs in rising and falling markets. The remaining monthly performance numbers can be safely ignored.

Another way to evaluate the characteristics of performance is to look at the graph of the index over a long period of time. Take a pen and mark the top and bottom of market cycles. If you want to be more precise, you can mark the periods when the index was flat too. These obviously will be of different durations. Now, evaluate the fund performance in these periods. You should be able to get a good idea of what performance to expect in various market conditions.

The other factor to remember is that the size of the fund affects performance. The relationship between size and performance is complex. A small fund can take advantage of mispriced opportunities better than a large fund. But a large fund has the necessary resources to invest in research to find the mispriced opportunities. It is, therefore, reasonable to assume that eventually it will depend on the team managing the fund and their breadth and depth of knowledge in spotting opportunities. However, as a potential investor, when one looks at past performance, one should remember to look at the corresponding size of the fund too.

There are certain commonly used mathematical ratios that claim to measure returns per unit of risk. Conceptually these may be elegant formulations, but the way they measure risk is inaccurate. Using daily volatility of the net asset value of the fund as a proxy of risk may be okay for someone investing with an investment horizon of a day, but has no meaning for someone investing for long periods of time. You can, therefore, ignore any ratio that uses this parameter as an input. After all, if volatility is a measure of risk then these ratios would only recommend bank deposits as investments. The reason being, deposits are not volatile and therefore when volatility is used in the denominator of a mathematical formula, the answer would be infinity—the best possible result.

Many like to analyse the constituent stocks and their movement in the portfolio of the fund. This is not essential to do and the above measures are sufficient to understand the characteristics of portfolio performance. Nevertheless, if you do want to understand more about individual stocks in the fund, then restrict it to two kinds of observations.

First, find the ‘active share’ of the portfolio. This is the amount of money invested by the fund in stocks that are away from the index. The higher the number, the greater the chances of the fund outperforming (or underperforming) the index.

Second, instead of looking at all purchases and sales the fund made on a monthly basis, look for the outliers. Say, an unexpected event happens which causes a significant price impact on one of the stocks in the portfolio. One can then see how the manager of the fund reacted to the news based on whether the stock was bought or sold or remained in the portfolio.

If you have a view on the event and if you were managing the portfolio yourself, you can then evaluate whether you like and agree with what your fund manager has done or not. Over a period of time you will be able to get insights into the manager’s behaviour, which will help you choose the best custodian for your capital.

Finally, do remember to start a monthly investment into a low-cost index fund. And compare how the index fund investment is doing compared to the rest of your investments. It should give you a good real time idea whether the active managers in your portfolio are able to beat the index or not.

Huzaifa Husain is head-equities, PineBridge Investments India.

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