Understanding The Performance Of Your Fund

8.1 Understanding Returns

The most important question is: How much money has the fund made? It’s no wonder that this is the first thing people think about. People invest in hopes of making money, and returns tell you what the fund made in the past. Historical returns sell funds-that’s why mutual fund ads in financial magazines or newspapers often feature big mountain charts showing the funds’ returns.

Yet as hard as it might be to believe, a fund’s past returns are not particularly predictive of its future returns. (The best predictor of good returns? Low costs. Nonetheless, a fund’s past history can offer some clues about whether it’s worth owning.

To make sense of the return numbers in advertisements, fund company literature, the newspaper, and on Morningstar.com, the first thing you should know is that these figures are based on important conventions. For starters, the numbers are known as total returns because they reflect two things: market gains (or losses) in the stocks or bonds the fund owns-the fund’s capital return-and income received from those investments

Income comes from the dividends paid by stocks and the interest paid by bonds the fund owns. Together, those capital returns and income returns make up total returns. Total-return numbers for periods longer than one year are typically represented as annualized returns.

An annualized return is something like an average, except that it takes compounding into account (i.e., it recognizes that if you made gains in the first year that you owned a fund, you have more to invest at the beginning of the next year). ICICI Pru Bluechip Fund had a three-year annualized return of 15.53%. The fund never actually earned that exact amount in any year.

8.2. Checking the After-tax Return

The total-return number is calculated on the assumption that shareholders reinvest any distributions that the fund makes. Mutual funds are required by law to distribute, or pay out, almost all income they receive (from dividend paying stocks or interest-paying bonds) to their shareholders. They also must distribute any gains they realize by selling stocks or bonds at a profit. If you choose to reinvest those distributions, and most investors do, you will get more fund shares instead of a check in the mail. If you decide to take the money, your returns may be lower than those of someone who reinvested and got more shares.

If you own your funds in a taxable account instead of tax saving schemes, you should know that the total-return figures you typically see don’t include the bite taxes can take out of your return. When a fund distributes income or capital gains to shareholders, it’s called a taxable event. And, of course, paying taxes cuts into the money you made. The difference can be significant.

The taxation rate of capital gains of mutual funds depends on the holding period and type of mutual fund. The holding period is the duration for which the mutual fund units were held by an investor. In simple words, the holding period is the time between the date of the purchase and sale of mutual fund units. Capital gains realised on selling units of mutual funds are categorised as follows:

8.3. Using Index as a Benchmark

An index is the most common kind of benchmark. When you read a fund’s shareholder report, you will always see the fund compared with an index, sometimes more than one. An index is a preselected, widely recognized group of securities, either stocks or bonds.

Ask someone to name a stock market index and odds are good that the answer will be Sensex. You can’t escape the Sensex-it’s the index that usually heads the stock report on the evening news. Although the Sensex is familiar, it isn’t a great performance benchmark for your mutual funds because it is extremely narrow; it includes just 30 large company stocks. Most stock funds include many more holdings and do not focus solely on blue chips.

Instead, the index you’ll hear about most often in investing circles is the Nifty 50 index, which includes 50 major Indian companies. Because NSE chooses the stocks in the index to cover a range of industries, it has greater breadth than the Sensex. Thus, it’s a reasonable yardstick for many funds that focus on big, name-brand Indian stocks.

Yet despite widespread use, the Nifty 50 has its own drawbacks. Although it encompasses 50 stocks, it’s designed so that the companies with the biggest market capitalizations (the total value of their outstanding shares), such as Reliance and TCS, take up the greatest percentage of the index. As a result, such names tend to influence the index’s performance. On days when these giants do well, so does Nifty50.

That’s why you wouldn’t want to compare a fund that focuses mostly on small companies, such as Axis Small cap fund, against the Nifty50 index alone. Small-company stocks make up a very small portion of the index, so it would be surprising if the fund performed much like the index at all.

So what indexes should you use to make appropriate comparisons? If you’re examining a small-company fund, use the BSE 250 Small cap benchmark, which is dedicated to small-capitalization stocks.

8.4 Using Peer Groups as Benchmarks

Indexes can be useful, but peer groups such as the same category funds, are even better because they allow you to compare the fund with other funds that invest in the same way. An index may be a suitable benchmark because it tracks the same kinds of stocks that a fund invests in, an index itself isn’t an investment option. Your choice isn’t between investing in a fund and an index but between a fund and a fund.

If you’re trying to evaluate a fund that invests in large, cheaply priced companies, compare it with other large-value funds. Armed with information about a fund’s true peer group, you’re in a much better position to judge its performance.

Say you owned Kotak Bluechip Fund. At the end of that year, you might have been very happy- sure, your fund made 17.43% for the year, but the BSE 100 gave return of 15.93%. Alongside that benchmark, your fund over performed. Also when you compare it with other funds of the same category: Kotak Bluechip fund has done better than ICICI Pru Bluechip fund & Axis Bluechip fund.

Looking at just the index doesn’t give complete insight into how your fund really did, but comparing the fund with its category tells you how well it does.

8.5 Return History Longer the Better

You can check a fund’s returns versus its category on various websites. But which returns should you consider? How the fund did for the past 6 months, the past 3 years or past 5 years, or some period in between?

Because studies show that trading in and out of funds doesn’t work, be a long-term investor and focus on a fund’s returns for the past 3, 5, and 10 years. Compare those returns with those of other funds in the category to get a clear view of performance. Although we wouldn’t rule out a fund that was below par for one of those periods, there’s little reason to buy a fund that’s inferior for most periods.

Take a look at the fund’s calendar-year returns versus its category, too. That’s a handy way to identify a fund that may look good because of a couple of strong recent years but has little to recommend it overall.

Finally, ask how long the fund’s current manager has been aboard the fund. Maybe the fund sports terrific long-term returns over every period, but the person who helped deliver those great returns has retired or moved on to another fund. In that case, the fund’s long-term record may have little bearing on how it will perform in the future