Mutual Fund Performance Evaluation

Learn about various metrics and techniques used to evaluate mutual fund performance for informed investment decisions.
Mutual Fund Performance Evaluation
3 min
24-April-2024

Mutual funds are diversified investments whose returns are influenced by a variety of factors. If you have invested in a mutual fund, you need to evaluate the performance of the scheme at periodic intervals to check if it remains aligned with your financial goals or if you need to rebalance your portfolio.

In this article, we examine what the performance of a fund means, explore how to evaluate mutual fund performance and see why it is important.

What is mutual fund performance?

The term ‘performance of a mutual fund’ typically refers to the returns the fund delivers. While you can quantify the returns as a percentage of the investment made, it is also essential to evaluate the performance and assess if the fund has performed poorly, above par or excellently.

This leads us to the question of how to evaluate mutual fund performance. To do this, you can use various benchmarks and parameters — some of which are internal to the fund and others that are external factors. Ultimately, the choice of the best method to evaluate the performance depends on the information available, the type of fund and your financial goals.

How to evaluate mutual fund performance?

Let us check out the different methods and parameters you can use to analyse and evaluate the performance of a mutual fund scheme in your portfolio.

Use a benchmark to evaluate the fund’s performance

A benchmark is a pre-existing index or a group of securities that are similar to the constituents of the basket of assets in a mutual fund’s portfolio. Every mutual fund has one or more benchmark indexes that are used to evaluate the performance of the fund and assess if it has underperformed or outperformed over a given period.
Some financial measures that you can use to evaluate the performance relative to a benchmark or the market at large include the alpha and beta of a fund.

The alpha tells you the excess returns a mutual fund generates in comparison to a benchmark — after it has been adjusted for the risk involved. It is represented as a percentage or an absolute value. For instance, if a mutual fund scheme has an alpha of +4, it indicates that the fund performed 4% better than the benchmark.

The beta of a mutual fund quantifies how sensitive the fund’s performance is when compared with a benchmark or the broad market. For instance, a beta of 1.3 indicates that the fund is 30% more volatile than (but moves in the same direction as) the benchmark, while a beta of negative 1.4 indicates that a fund is 40% more volatile than (but moves in the opposite direction to) the market/benchmark.

Compare with the performance of peer funds

Another way to evaluate the performance of a mutual fund is to compare its returns and risks with other similar funds in the same category. For instance, say you make a SIP investment in an index mutual fund. One year later, you can evaluate the performance of this fund by comparing its returns to other funds that track the same index.

This will help you check if the fund has performed optimally or if it has a higher tracking error than other funds in the same category.

Measure against historical performance

You can also evaluate the performance of a fund by comparing its current returns with its historical performance. To do this, you must first analyse the historical returns from a mutual fund and assess how it has performed in different market cycles. Check how the fund’s returns have reacted to specific events that affected the broad market, the sector or the theme that the fund has adopted. You must also evaluate the performance of the fund during periods of managerial changes.

Such extensive analysis helps you understand how the fund aligns with your risk tolerance and your goals. You can compare mutual funds and choose those that have consistently performed well in the previous years.

Check the risk-adjusted returns

Every mutual fund carries different kinds of risks. To evaluate the performance of a fund comprehensively, you need to look at the risk-adjusted returns rather than the absolute returns. Financial metrics like the Treynor ratio and the Sharpe ratio can help you with this.

  • Treynor ratio:  Treynor ratio focuses on systematic risk, using beta as the measure. Beta reflects how a fund's returns move with the market.
  • Sharpe ratio: It considers total risk, using standard deviation as the measure. Standard deviation captures all the ups and downs of a fund's returns, including those from both market movements and individual company performance.

In simpler terms, the Treynor ratio rewards funds that generate high returns for the market risk they take on, while the Sharpe ratio rewards funds that deliver high returns relative to their overall volatility.

Check the rolling returns from the fund

If you want to evaluate the performance of a mutual fund without having the results skewed by recent returns data, this method can help. The rolling returns are essentially calculated on a continuous rather than a discrete basis.

Here, you get to break down the returns into smaller bits like monthly, quarterly or yearly returns instead of looking at the overall returns since inception. This helps you evaluate the performance of the fund during different market conditions and over different timeframes.