Equity Linked Saving Scheme (ELSS Funds)
Fund Ratios, Performance Consistency And Fund Rating
Previously we have learned how ratio analysis can be helpful in choosing the best ELSS funds. Ratios like Sharpe Ratio can help you to understand the risk and return potential of all the funds. So, in this unit, we will learn to evaluate a fund based on ratios, performance consistency and its rating.
A. Fund Ratios
1. Standard deviation
Standard deviation is a widely accepted measure of risk. It will tell you how risky the fund is, i.e. What is the chance that the fund will not be able to generate the expected returns in the future.
How to evaluate?
It is always better to choose a fund with low standard deviation.
Beta is widely accepted as a measure of the volatility of the funds. It will give you an idea of how much volatility in the ELSS fund returns you can expect when the markets move up or down.
Funds with a Beta of 1 are expected to move exactly in the same way as the market moves. Those with the Beta of more than 1 will witness higher volatility than the market. Those with a Beta of less than 1 have a lower volatility than the market.
For example, if the market moves up or down by 100 points, then the stocks with different Beta will move as follows:
How to evaluate?
- If you are a conservative investor then choose a volatility less than 1.
- If you want the ELSS to generate returns in line with the market returns, then choose a fund with Beta of 1
- However, if you have the appetite for higher risk and want high returns, then you should choose an aggressive ELSS which has a Beta greater than 1.
3. Sharpe Ratio
Sharpe ratio measures the risk-adjusted returns generated by a fund. Higher Sharpe ratio means that you are getting better returns vis-a-vis the risk that you are taking.
Sharpe ratio is calculated as:
Sharpe ratio = (Average Returns Generated By The Fund – Risk-Free Rate) / Standard Deviation Of The Returns Of The Fund.
How to evaluate?
You should look for funds with higher Sharpe ratio as they will give you better returns compared to the risk that you would be taking by investing in them Treynor ratio.
4. Treynor Ratio
Treynor ratio is another risk-adjusted measure of the returns generated by a fund. While Sharpe ratio uses standard deviation as a measure of the risk, Treynor ratio uses Beta.
Treynor ratio is calculated as:
Treynor Ratio = (Average Fund Return – Risk-Free Rate) / Beta Of The Fund
How to evaluate?
You should look for funds with a higher Sharpe ratio as they will give you better returns compared to the risk that you would be taking by investing in them.
B. Performance Consistency Of ELSS
All investors should look at the track record of the ELSS to determine how consistent their returns are. It is always important that you choose a fund which has generated consistent returns year on year. The funds whose returns are not very consistent are the ones who earn huge returns in one year when the markets are favorable and struggle to generate any returns when the markets are bad. It is very risky to invest in an ELSS whose returns are highly volatile.
Hence you need to look at the past performance of the ELSS to understand their track record. Now one common mistake that most investors make is that they look at the returns of the past 1 or 2 years to determine whether the fund is good or not. This is the wrong way of checking the performance consistency of ELSS.
Since ELSS investment is a long-term one, always try to check the 3-year and 5-year returns. If the fund has been in existence for many years then you can also check the returns generated by the fund since its inception. This will give you a better idea of its performance consistency and will give you an idea about what to expect in the future, provided the market does not crash. It is a great way to choose the best fund from the plethora of ELSS that are available in the market today.
C. Fund Rating
Many independent agencies compare the performance of the funds and assign ratings to them. While investing in an ELSS you should look at these fund ratings to identify the top performers. Since fund rating is done by third party agencies like Value Research and CRISIL, these are considered to be authentic and reliable by the investors.
The ratings that are given by Value Research range from 5 stars to 1 star. They do separate ratings based on the 3-year returns and 5-year returns of the funds and then arrive at a composite rating for each fund. If any fund has been in existence for less than 3 years or has an AUM of less than 5 crores, then it is not rated.
CRISIL on the other hand does mutual fund ranking. They consider portfolio and NAV based parameters of the funds for deciding on the rankings. They also consider asset quality, risk-adjusted returns, liquidity, etc. of each fund.
Before investing in the ELS you need to compare the funds based on their ratings and rankings. This will help you to avoid choosing the wrong funds which can prove to be a costly mistake.