Measuring Mutual Fund Returns
Risk and Return go hand in hand for any investment and the main purpose of investing is to earn returns. Right?
So, an obvious question for any discussion about mutual funds will be how to measure returns?
Like any other financial product, the returns on mutual funds can be measured in various ways.
Here, we have discussed some common ones.
1. Absolute Returns
The simplest way to calculate returns is to determine how much you invested and how much you got. This is an absolute return.
For example, on 1st April 2020, you invested ₹10,000 in a mutual fund scheme. On 31st March 2021, it was worth ₹ 14,000. Thus your absolute return is 40% [(₹ 4,000/10,000)/100]
But then, things are not so simple in real life. You will not withdraw your funds exactly at the end of 1 year, right?
Hence, Compounded Average Growth Rate or CAGR is an efficient way of measuring absolute returns. It measures the rate at which your investment is growing.
So, let’s suppose you invested ₹10,000 on 1st April 2018. After 3 years, the value of your investment is ₹25,000. So the CAGR of your investment is:
Rolling returns, however, provide a better picture of a fund’s performance than CAGR. We have discussed this in detail in the coming chapter.
As we mentioned while discussing the benchmark, each mutual fund’s performance is measured vis-à-vis a benchmark. This is a great way to understand whether the scheme has performed well or not against a given standard.
The ratio which measures a mutual fund’s performance against a benchmark is known as Alpha. Alpha reflects the return generated by a scheme. Ideally, Alpha should be higher than the Sharpe Ratio since the Sharpe Ratio measures return vis-à-vis risk-free return of the market.
While selecting a mutual fund, consider those which have generated a positive alpha consistently over time.
4. Sharpe Ratio
Risk-adjusted return is the return that your portfolio generates for the risk taken during the given time. It is measured by the Sharpe Ratio, which we have discussed in detail in chapter 11 of this module.
5. Treynor’s Ratio
This ratio measures how much excess return was generated for each unit of risk taken by the portfolio. By excess return, we mean the return earned over and above the risk-free environment. Higher Treynor’s Ratio means that the fund has generated better returns for the amount of risk taken for each unit.
Let us now see the Alpha, Sharpe Ratio, and Treynor’s Ratio of some of the most popular bluechip mutual funds:
Data were taken on 30.09.2021