Why some funds perform better than others?

Why some funds perform better than others

Why some funds perform better than others?

There are more than 10,000 mutual fund schemes available in the market but only a few of them are able to deliver good performance. In this article we will delve upon the reasons of some funds performing better than others but let us first discuss what constitutes a good performance for a fund.

How to evaluate performance

A. Categories

Performance is measured in terms of returns. The fund giving better returns than the other is considered a better fund. However, one must check which two funds are being compared. There are different categories of mutual funds.

1. Equity & Debt

Debt funds are considered safe and they generally give lower returns than the volatile Equity Fund category. Since these two categories are vastly different, while comparing returns of two funds, the first classification to be made is that if it is an equity fund or a debt fund.

2. Sub-Categories

Within the broad categories of Equity & Debt funds, there are different sub-categories which differ in the risk associated with them. For example, Large Cap funds are less risky than Small Cap funds. In long term Small cap funds are believed to give more returns but with higher standard deviation. Similarly in debt funds, there are credit opportunities fund which invest in lower rated bonds to get higher returns.

Hence, when we compare performance of the funds, we need to check if the funds belong to the same sub category or not.

B. Investment Horizon

When comparing two funds, the comparison should be for the same time horizon over multiple periods. One fund may perform better in one year, and another in other year. Hence the consistency of the performance is important. Also, the comparison should be done over ideal time horizon of the funds, for example: Large cap equity funds are suitable for a horizon of 5 or more years; hence the comparison of 2 large cap funds should be done over different periods of at least 5 year performance.

Why some funds perform better?

The funds that belong to same sub-category, can display varied performance, let us look into the reasons for the same:

  1. Risks

A well performing fund might be taking more risky calls and once they paid off, the fund gets better returns than the other funds of the category. For example, if a large cap fund invests a higher than average percentage of portfolio in mid cap or small cap funds, then it might get higher returns too.

Is taking more risks good or bad?

Let us first talk about Equity funds.

If the fund has been getting consistent good returns by taking higher risks, then the fund can be considered good. However, the investor should be comfortable with such kind of higher risks because in the future risky investments might not work out and the performance can vary.

In debt funds, taking higher risk is not advisable as debt investments are to provide safety to the overall portfolio.

  1. Fund Manager

Fund managers bring a lot to the table and a fund manager who has experience of different market cycles can be the difference in the fund performance. The fund manager performance can be tracked by the ratio called Alpha. The excessive return of the fund over the benchmark is called as alpha. A positive alpha of 1 means that fund has outperformed the benchmark by 1%.

However, this does not mean that one should panic if a well performing fund manager leaves a fund as there are many other factors which affect the fund performance and new fund manager needs some time to prove himself/herself.

  1. Fund Size

Fund size also affects the performance. A small sized fund can get impacted if a big investor takes the money out or if there are large number of outflows. On the other hand a very big sized fund might not find opportunities to invest in, affecting the performance. This is more important in case of mid cap and small cap funds as the avenues in these categories are limited.

  1. Expense Ratio

A fund’s expense ratio is the fee charged by the AMC to manage the fund. A high expense ratio can eat into your returns. Since 2013 each fund has its direct plan variant in which no commission is paid to the intermediaries and hence its expense ratio is lower resulting in higher returns to the investor. Whenever investing, one must check if the fund is the direct plan or not.

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Hope, you now understand the reasons why some funds perform better than others and also learned the basics of how to compare different funds and can apply this knowledge on your portfolio.

To know more about mutual funds, you may check our blog series on Mutual Fund Basics.

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