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)