There are many financial ratios like standard deviation, alpha, beta, sharpe ratio, etc. that can help you understand the performance of a mutual fund. However, these ratios don’t inform much about the factors that affect the performance of a mutual fund. In this article, we will look into the determinants of mutual fund performance. Read on!
In this article
Performance of the Underlying Securities
A mutual fund invests in a basket of securities based on the asset allocation defined in the scheme documents. So, if a fund has specified that it would invest around 80% of its investible corpus in equities and equity-related instruments and the remaining 20% in debt and money market instruments, then the fund manager ensures that this ratio is maintained while investing.
Since the fund invests in certain securities, the performance of the fund depends on how these securities perform. In the above example, if the stock markets crash, then 80% of the fund’s portfolio gets impacted.
However, while investing in securities, the fund managers can diversify across sectors, market capitalizations, geographies, etc. based on their understanding of the economy.
If the fund managers have diversified and/or hedged efficiently, the impact can be muted to a great extent. In a nutshell, the fund will perform based on how the underlying securities perform.
Economic Changes in Certain Sectors/Industries
One of the most important factors affecting mutual fund investments is the performance of a specific sector or industry that the fund is invested in. Certain policy changes implemented by the government can impact different sectors in different ways. Let’s say that certain policy changes boost the demand for real estate in the country.
This leads to a sudden increase in the number of construction projects and a subsequent increase in demand for materials like steel, cement, etc. Hence, the stock prices of companies manufacturing these materials increases.
If the mutual has invested in these sectors, then it will experience a boost in performance. On the other hand, if a policy change impacts a sector or industry negatively, then the stocks of companies in the sector and those associated with it drop in value and cause a negative ripple effect on the mutual fund scheme.
Since a fund house manages the investment on your behalf, there are certain expenses and fees that need to be paid by you. The expense ratio of a mutual fund includes all costs and fees associated with running and managing the fund including management fees, distribution fees, shareholder fees, administration fees, etc.
Usually, the expense ratio of a mutual fund ranges between 0.5 and 3 percent depending on a range of factors. This can minimize the overall returns.
A mutual fund pools money from investors with similar risk tolerance and financial goals and invests it in different securities. If there are a large number of investors looking to invest in a particular mutual fund scheme, then fund managers have more investible funds in hand and can widen the range of investments increasing the chances of making good returns for the fund.
On the other hand, if the fund is performing below expectations, investors might pull out their investments causing the fund manager to sell off holdings to manage the redemption requests. This can have a negative impact on the cash flow and may affect the performance of the fund further.
Size of the Fund
The size of the fund also plays an important role in its performance. While in the previous point I mentioned that positive cash flows can help boost the performance of the fund, it is important to understand that as the size of the fund increases, the responsibility of the fund manager increases too. Also, if the fund grows in size beyond a certain point, it becomes difficult to manage. A large fund that is poorly managed tends to perform poorly.
As you can see, since the fund manager makes all the crucial decisions with respect to the mutual fund, the skills of the fund manager are an important aspect. For you as an investor, keeping track of the latest developments and events that can impact sectors or industries is important. Lastly, looking at aspects like the expense ratio, fund size, and cash flows can help you get a grip over the factors affecting mutual fund performance and increase your preparedness.