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Tuesday, October 25, 2011

Prajna Capital

How should you compare Fixed Income Instruments?

Posted: 24 Oct 2011 11:43 PM PDT

When choosing fixed income investments, investors often end up comparing the past with the future. This sounds like a strange mistake to make but investors do it inadvertently. However, it's still something that can mislead them and result in the wrong (or at least sub-optimal) investment decisions.

How this happens is actually straightforward. When you're looking to choose a fixed income investment, you have a range of options to choose from a range of different options. Typically, you would compare bank deposits, fixed income mutual funds (both open-end and fixed maturity FMPs, and a few others. Functionally, in terms of what they deliver to the investor, these are close alternatives. However, they work in very different ways. Bank (or company) fixed deposits are guaranteed instruments where you are told what you will earn over the coming times.

Fixed income mutual funds, and other market-based instruments cannot tell you what they will earn in the future. Instead, you typically make a choice based on what the same fund, or that type of fund earned in the past. This can make a big difference, and the difference is particularly important when interest rates are changing, as they are now—or indeed, as they have been doing so almost continuously for many years now.

Fixed deposit rates for a one year term are 10 per cent or a little more. However, if you look at the one-year return for the various shorter-term debt funds on ValueResearchOnline.com, the catgeories' average ranges from 7.4 to 8 per cent. Does that mean that debt mutual funds are going to earn that much less than bank deposits? Not quite. It just means that you are comparing the past with the future. The fund returns are the actual returns over the past one year. The FD returns are what will be delivered over the next one year. For fixed income investors 1 or two per cent is a big differential. However, to get the right answers, one needs to make sure that one is not making an apples to oranges comparison.

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How to measure Performance of the Mutual fund?

Posted: 24 Oct 2011 09:13 PM PDT

Though performance of a scheme is an important parameter which helps us to gauge a fund's past performance, its consistency in delivering returns, etc., it is imperative to recognise that it is not the only parameter. Thus, you as an investor should not jump to conclusion about a fund based on its performance only.

Moreover under the performance criteria, we must make a note of the following parameters too:

· Comparisons: It is very important to compare the performance of the funds in the same category so as to arrive at a fund which stands out among its peers. Analysing a fund in isolation is of no relevance. Thus, comparing similar funds is vital before you take any investment decision.

· Time period: When you opt for equity diversified fund for investment make sure your investment time horizon is at least 3 years. Long term investing is the best way to generate wealth. Also, a fund will do well when the stock markets are experiencing euphoria but the core strength of a fund is brought when there is a downturn in the markets. Thus, a fund's performance must be analysed across different market cycles or time periods.

· Returns: Returns are one of the important parameters that one must look at while evaluating a fund. But remember, although it is one of the most important, it is not the only parameter. Many investors simply invest in a fund because it has given higher returns. In our opinion, such an approach for making investments is incomplete. In addition to the returns, investors must also look at the risk parameters, which explain how much risk the fund has taken to clock higher returns.

· Risk: You as an investor must know as to what degree of risk you are exposed to when you invest in a particular fund. This risk in a fund is normally measured by Standard Deviation (SD). A fund with a low SD is preferable to its peer with a higher SD (from the same category).

· Risk-adjusted return: Having a low SD is not enough by itself. A true performing fund will not only keep its SD under check but also generate luring risk-adjusted returns for its investors. This risk-adjusted return is normally measured by the Sharpe Ratio (SR). Thus the SR of your fund will tell you whether it is worth taking risk that level of risk.

· Portfolio Concentration: Whenever a fund clings to limited stocks in its portfolio, the fortunes of the fund get closely linked to those of the underlying stocks. Thus, a fund having a high portfolio concentration is exposed to higher risks than those funds which have well diversified portfolio across sectors and market caps.

· Portfolio Turnover: High churning (frequently buying and selling stocks in a portfolio) in a fund's portfolio leads to high volatility. Also, you investors are exposed to high transaction costs incurred by the fund manager due to frequent churning. As opposed to this a fund which follows a 'buy and hold' strategy gives stable returns.