The data for evaluating mutual fund can be found in its prospectus, quarterly and annual reports. The following financial parameters should be used in analyzing a mutual fund and its management:
1. Total Return
Total Return indicates the impact of appreciation of its value and dividends (if any). It is becoming increasingly common to find total-return numbers published in newspapers, magazines or other sources. One can calculate total return using the following formula:
Total Return (TR) = [(Distributions + Change in NAV)/NAV at the beginning of the period] x 100
Distribution is the income received by the investors for having their money in the mutual fund. The components of dividends are stock dividends, bond interest etc.
2. Expense Ratio
Expense Ratio is the ratio of total recurring expenses (fees, commission etc.) to average net assets. Lower numbers are desirable. Since the expense ratio fluctuates, it is better to compute an average over the last three or five years. There are certain important aspects related to expense ratio.
Small funds tend to have higher expense ratios than larger ones, which benefit from economies of scales since their management fees and other costs are being spread over a bigger asset base. Stock funds have higher expense ratio when compared with the fixed income securities. Funds that invest internationally tend to have higher expense ratios compared to domestic portfolios due to higher cost on research and foreign investment
3. Portfolio Turnover
Portfolio Turnover measures the amount of buying and selling done by the management. It is defined as the lesser of assets purchased or sold divided by the funds’ net assets. A 100% turnover implies that management holds each stock or bond on average for one year, 50% for about two years and 200% for six months and so on. Turnover varies by type of fund and the investment philosophy of the manager. Some managers seek quick profits and will tend to buy and sell aggressively. Some follow long-term buy and hold strategy. Funds that rely on futures, options and short-selling strategies could be expected to have high turnovers and transaction costs.
4. Good Performers
The past performance should not be taken into account while analyzing a fund. A comparison should be made with similar funds to gauge the relative performance of the scheme during the specified period. Performance, when compared with market return will show whether the scheme has outperformed the market or not. Investors should avoid those funds that have logged consistently below par-results over several years. Investors should also take into account the fact that a good performance in a particular scheme by mutual fund does not imply that same performance would be repeated in other schemes.
5. Size of the Fund
A funds’ size or total assets is another factor to consider.The following are the advantages of small portfolios:
- Easier to maneuver: It is easier to reshuffle holdings in small funds than in large funds. It would be difficult and time consuming for large funds to eliminate certain big positions. To minimize the adverse price impacts of selling large holdings, the stock might have to be sold into the market gradually over a period of several weeks or months.
- Lower expense ratio: With more assets under management, large funds will enjoy economies of scale. Other things being equal, lower expense ratios lead to improved results.
- Large funds attract and retain better talent: The organizations that run large funds are generally prestigious and have the money to compensate the best portfolio managers and analysts.
- Certain funds do best with large portfolios: Money market and debt funds can perform better with more assets due to the nature of the fixed income markets. In such funds transaction sizes tend to be very large and bigger blocks, will provide a better return along with minimizing transaction costs.
6. Cash Flows
Cash Flows refers to the net new money invested in a mutual fund or in other words, it is the excess of new purchases over redemption during a specified period. The following are the main advantages of large net cash inflow that may accrue to the mutual fund scheme:
- The fund manager can use the new money to add to positions in stocks he or she already holds. This additional demand will normally raise the price of the stock. More so, if the fund invests in smaller firms with shares outstanding.
- The manager would not have to sell stock X to buy Y. The fresh money would be invested in Y allowing X to remain in the portfolio with an additional chance to grow.
7. Analyzing Fund Management
The return on a fund depends not only on the quality of portfolio but also on the quality of management. An asset management company manages the mutual fund. The performance of mutual fund depends on the amount of expertise available with the managing company. The fund managers are crucial as the return depends on their investment strategies. The information about their qualification and experience is given in the performance report.