Evaluating Mutual Fund Performance ( JENSON ALPHA )

Nurture India Consultant Risk Management Series for Financial Literacy

Evaluating Mutual Fund Performance ( JENSON ALPHA )

I have always been an advocate of managing risk and not about chasing return. Its just like one is more concerned about speed and reaching destination quickly whereas a sensible driver will manage the accelerator and brake in best possible manner looking at road and traffic situation. Second driver concern is not reaching fast and quickly with risk of accident but reaching safely even taking few minutes more. Managing risk in mutual fund should be like 2^nd driver and not 1^st one.

We have been seeing most investors, analysts, experts evaluating fund on return given or risk managed but vis a vis what???? Market or Peer group. Ideally it should be vis a vis the risk taken by that fund manager itself.

Alpha: For most people it means Fund Return minus Benchmark return. So within same category say Multicap Fund if 3 funds (A, B, C) have given return of say 12%, 13% and 15% and benchmark (same indices) has given say 10% return then the alpha as understood by many investors is

Fund A = 12-10=2%

Fund B = 13-10 = 3%

Fund C = 15-10 = 5%

Its looks C is best, B 2^nd best and A is the last performer in the three.

Do we know how smartly the fund manager has been able to judge economic and market trends and factors , what industry sector weightage in the respective portfolio  , similarly weightage in different companies . Looking at the economic and market condition fund manager will increase or decrease industry wise and company wise allocation. How frequent and how much he is buying and selling (Portfolio Turnover Ratio) to manage the risk and return etc etc .  

Its not easy for a normal investor to track on too frequent basis and so the easiest way to judge between good and bad performer for most is above stated Alpha and trend of the alpha in different time duration.

We always say “higher the risk higher the return “. But does this apply only for investors? In my view this applies for Fund Manager also.  if a fund manager has taken higher risk then he should generate higher return also.

Now when I evaluate the fund performance it will not be alpha over benchmark but alpha over the risk which the fund manager has taken which is called Jenson Alpha.

Any investor who invest expects (1) at least a minimum return which the economy can give ((risk-free return i.e. T Bill or G sec yield ), (2) market risk premium over risk free return otherwise what was the sense of investing in risky market related investment i.e. (return of benchmark/indices - risk-free return). But the larger issue is how the economic and market risk has been managed (sector weight, company weight, portfolio turnover etc). As an investor I need to be compensated for that i.e. if the risk has been taken more I need more return (Higher the risk taken by Fund Manager higher should be the return) . That risk is measured by fund beta .

Now Jenson Alpha is = Fund Actual Return – Fund expected Return (based on risk taken)

Fund Expected return (based on risk taken) = Risk free return + Beta (Benchmark return - Risk free return)

Now let’s assume Risk free return is say 6%, benchmark return is 10% and Beta for A, B, and C is 1.1, 1.2 and 1.8.

Now Expected return will be as follow (in percentage)

A = 6 + 1.1 (10- 6) = 10.4

B = 6 + 1.2 (10-6) = 10.8

C = 6 + 1.8 (10-6) = 13.2

Now Jenson Alpha for the 3 funds are

A = 12-10.4 = 1.6

B = 13-10.8 = 2.1

C = 15-13.2 = 1.8

Now just see Is the performance same as earlier as done by most investors . Now B looks as best performer of the three and not C .

(Pl note – The above example is just a hypothetical one just to explain the concept of correctly evaluating the fund)

Understanding Risk and Return if investing in Equity Today

Understanding Risk and Return if investing in Equity Today

Many investment experts are telling to invest in equity as many stock and indices are 30 % to 40 % down from its peak ( Nov – Dec 2019 ) level . Can we superimpose past mathematical facts and calculate forward return ? . This time Risk is different from all risk what we have seen in the past. Last such similar type of health related risk (Spanish flu) was 100 years back . Sensex , the oldest indices came into existence in 1980. All previous recession was not having risk of today so just on the basis of past market indices data and movement we can not tell exactly by what time “x” return will come  . Yes but one thing is for sure that there will be upside but from when , how much can not be told.

Lets remember Risk is not dependent on  return but return is a function of risk . So we need to understand risk. 

Valuation at any point of time reflects all the risk incorporated by the market . But more than Valuation important is the trend of valuation ( falling/ rising  ) as that reflects the mindset ( fear/greed ) of market participants .

Valuation at any point is a static variable whereas trend of valuation is dynamic in nature i.e. changing regularly. Apart from Valuation level one should also give importance to trend in valuation.

The risk in Nov-Dec 2019 was not the same as what the risk is today and risk will not be same 6 month or 1 year or x year from now . Risk changes every second , every minute , every day . Change in Risk leads to trend ( fall/rise ) and the valuation .

In Dec 2019 – there was hardly any risk from Covid 19 .

Today – Covid 19 impact . heavy sell off from FIIs . The mindset of FIIs is aligned more with the Covid 19 impact in their economies . Stock market falling there . In india -- Domestic investors still holding by and large . Have we seen the worst of Covid 19 in India ????? . Has Indian Stock Market factored Covid risk in India . Please remember up till now its Indian Stock market impact is more from external risk and not from internal risk .

Tomorrow ( Short term ) – Much depends on Covid 19 impact ( external and internal ) . God forbid nos in India remain less and under control . But if that not happens then our stock market will factor this risk also .

Its not a question of 30 % discount sales but what’s ahead in short term and post Corona .

Post Corona Situation – (1) Since all countries are affected their economic policies will have domestic orientation. Will then FIIs and FDIs will invest in India and how much they will invest ?  (2) Banks were already under asset stress pre Corona . With businesses getting beaten , earnings will dip and chances of more NPAs in bank Balance sheet (3) Government will have lesser Corporate tax so will impact Government spending (4) Retail Individuals spending priority will change . Luxury and discretionary expenses will see reduction and impact on such industries . (5) Govt might resort to borrowing through G Sec and surplus money will move there (6) Even Corporate expenditure will see overall reduction and prioritisation w.r.t various head of expenditure and that will impact sales, revenue and profit .

A lot depends what will be government economic and industry policies and that will decide how quick India recovers back to normal level .

Best Strategy – hold cash as no one other than God knows if we have reached bottom .  Also your next 3 to 5 year defined planned major expenditure should be ensured by debt investment . If not done first do that .

After that If  have excessive surplus of cash and want to invest then invest in large cap with clear limit order . Go for stop loss or profit booking strategy . Put limit order with spread on bid/ask price . The spread should be realistic and realisable.

MF is the best Option – As managing the risk is key to investment there can not be better option than Equity Mutual Fund . Most of the risk and strategy which has been mentioned above will be taken care better here than direct investing . Whether evaluating Govt policies, industry wise exposure , Company wise allocation, Cash position , Tactical calls etc a research driven professional fund manager will do better than any other individual.  

SIP helps you to get invested in staggered way at different valuation level  . If you have lumpsum that one can invest in staggered way . say 10 % now . If fall of say 5% then next 10% and so on . But in either case the investment horizon must be minimum 5 year or more.

Rather than trading in direct Equity better will through MF ETFs with same stop loss, profit booking strategy with limit order with spread on bid/ask price .