What is a fund and why evaluate it?
A mutual fund collects money from many people and a professional fund manager invests it in shares, bonds or both. You own units. The price of one unit is the NAV (net asset value): the fund's total assets minus costs, divided by the number of units.
Thousands of funds exist (also called unit trusts or ETFs in some countries). Evaluation means checking whether a fund did a good job for the risk it took and the fee it charged, compared with fair alternatives.
Measuring return
Return is the gain as a percentage of what you started with.
- Holding period return = (end NAV − start NAV + dividends) ÷ start NAV × 100.
- Annualised return (CAGR): the steady yearly rate that gives the same final value: (end ÷ start)1/years − 1.
- Look at 3-, 5- and 10-year returns, not just last year. One lucky year proves little.
Absolute return is the plain gain; relative return is the gain compared with a benchmark.
Measuring risk
Risk means the result may differ from what you expect, including losses.
- Standard deviation (SD): how widely yearly returns spread around their average. Bigger SD = bumpier ride. It is total risk.
- Beta: how much the fund moves with the market. Beta 1 = moves like the market; 1.3 = 30% more; 0.7 = 30% less. It is market risk.
- Maximum drawdown: the biggest fall from a peak, for example −35% in a crash.
Other risks: credit risk (a bond issuer fails to pay), interest-rate risk (bond prices fall when rates rise), liquidity risk.
Performance measures: putting return and risk together
Risk-adjusted measures answer: "Was the return worth the risk?" The risk-free rate (Rf) is what a safe government bill or deposit pays.
- Sharpe ratio = (Rp − Rf) ÷ SD. Reward per unit of total risk.
- Treynor ratio = (Rp − Rf) ÷ beta. Reward per unit of market risk.
- Jensen's alpha = Rp − [Rf + beta × (Rm − Rf)]. Return above what the fund's beta "should" have earned. Positive alpha = manager added value.
Use them to compare funds of the same type over the same period.
Costs and other checks
Expense ratio: yearly fee as a % of your money. Exit load: fee for selling early. Also check fund size, the manager's track record, portfolio quality and tax.
Try it
Open any fund's fact sheet (free online). Note its 5-year return, SD and expense ratio, and its index's 5-year return. Work out the Sharpe ratio with Rf = 6%. Then use the sliders in step 6 to check.
Key formulas and definitions
- Return % = (End NAV − Start NAV + Dividend) ÷ Start NAV × 100
- CAGR = (End value ÷ Start value)^(1/n) − 1
- Sharpe ratio = (Rp − Rf) ÷ σp
- Treynor ratio = (Rp − Rf) ÷ βp
- Jensen's alpha = Rp − [Rf + βp (Rm − Rf)]
- Net return ≈ Gross return − Expense ratio
Worked examples
1. A fund's NAV rose from ₹50 to ₹56 and it paid a ₹1 dividend per unit. Find the return.
Gain = 56 − 50 + 1 = ₹7. Return = 7 ÷ 50 × 100 = 14%.
2. Fund X: return 14%, SD 8%. Fund Y: return 11%, SD 4%. Risk-free = 6%. Which has the better Sharpe ratio?
X: (14 − 6) ÷ 8 = 1.0. Y: (11 − 6) ÷ 4 = 1.25. Y is better per unit of risk, though X earned more.
3. A fund earned 15% with beta 1.2. Market return 12%, risk-free 6%. Find Jensen's alpha.
Expected = 6 + 1.2 × (12 − 6) = 6 + 7.2 = 13.2%. Alpha = 15 − 13.2 = +1.8%. The manager added value.
Common mistakes
- Choosing a fund only because it topped last year's return list.
- Comparing an equity fund's return with a debt fund's, as if risk were the same.
- Thinking a higher return always means a better fund; the Sharpe ratio may say otherwise.
- Ignoring the expense ratio because it "looks small"; over many years it adds up a lot.