Investors have a choice when it comes to mutual funds, but it is not always clear how to compare one to another.
The average rate of return is a useful measure, but most investors also rely upon the Net Asset Value as an indicator of the fund's performance.
While NAV does serve as an indicator of performance, it is not always reliable.
There are several factors or parameters, which can change the perception about performance.
NAV or the net asset value is one parameter.
It indicates the value of units at the end of a day.
It does not indicate how much was the initial investment and how long it took the fund to reach its present value.
For example, an investor bought 1 unit of $10 in mutual Fund A.
One year later the NAV of this unit was $12.
The return on investment would be $2.
Suppose the investor is comparing the returns of Fund A with Fund B.
As of date, the value of Fund B's one unit may be $6, but one year ago, it was $5.
In principle, the return is $1 per unit.
However, investor would have bought two units for his $10.
Therefore, returns from Fund B are also $2.
Comparison of returns is, therefore, in percentages rather than in currencies.
Fund A may have been around for a long time, but the NAV of its unit may only be equal or marginally higher than the NAV of Fund B's unit, which may be comparatively a new comer on the scene.
However, it is difficult to compare performances pro-rata because market conditions vary from time to time.
This is the reason analysts compare cumulative returns for making them comparable.
They usually compare percentage returns in preceding one year, cumulative returns in preceding three years, and cumulative returns in preceding five years.
Analysts also ensure that the returns relate to the identical periods under comparison.
Therefore, they would compare the performance of all mutual funds in each year.
The age of the management company matters, especially if it has been a consistent performer.
Therefore, all other factors being equal, a management company that has been around for longer is better than investing in a new one.
Another mistake people make is comparing different varieties of funds.
There are funds that distribute part of their profits, and there are others that reinvest these profits.
Obviously, the two are not comparable because one that distributes part of the profits would obviously have lower NAV.
Similarly, those that focus only on one sector like infrastructure are not comparable with diversified or balanced mutual funds.
Diversified investments spread their risk across different sectors instead of focusing on one sector.
Balanced investments focus partly in equities and partly in fixed returns fetching instruments.
Mutual funds are most often compared to a benchmark such as NASDAQ, NYSE, or Standard & Poor indices.
This selection is an indication that the fund manager has set a bar for the fund.
In other words, the returns fund would be comparable with returns from such indexes.
If the investor is comparing against such indexes, then it is necessary to ensure that comparison is with the chosen benchmark index, and not any other index.
The average rate of return is a useful measure, but most investors also rely upon the Net Asset Value as an indicator of the fund's performance.
While NAV does serve as an indicator of performance, it is not always reliable.
There are several factors or parameters, which can change the perception about performance.
NAV or the net asset value is one parameter.
It indicates the value of units at the end of a day.
It does not indicate how much was the initial investment and how long it took the fund to reach its present value.
For example, an investor bought 1 unit of $10 in mutual Fund A.
One year later the NAV of this unit was $12.
The return on investment would be $2.
Suppose the investor is comparing the returns of Fund A with Fund B.
As of date, the value of Fund B's one unit may be $6, but one year ago, it was $5.
In principle, the return is $1 per unit.
However, investor would have bought two units for his $10.
Therefore, returns from Fund B are also $2.
Comparison of returns is, therefore, in percentages rather than in currencies.
Fund A may have been around for a long time, but the NAV of its unit may only be equal or marginally higher than the NAV of Fund B's unit, which may be comparatively a new comer on the scene.
However, it is difficult to compare performances pro-rata because market conditions vary from time to time.
This is the reason analysts compare cumulative returns for making them comparable.
They usually compare percentage returns in preceding one year, cumulative returns in preceding three years, and cumulative returns in preceding five years.
Analysts also ensure that the returns relate to the identical periods under comparison.
Therefore, they would compare the performance of all mutual funds in each year.
The age of the management company matters, especially if it has been a consistent performer.
Therefore, all other factors being equal, a management company that has been around for longer is better than investing in a new one.
Another mistake people make is comparing different varieties of funds.
There are funds that distribute part of their profits, and there are others that reinvest these profits.
Obviously, the two are not comparable because one that distributes part of the profits would obviously have lower NAV.
Similarly, those that focus only on one sector like infrastructure are not comparable with diversified or balanced mutual funds.
Diversified investments spread their risk across different sectors instead of focusing on one sector.
Balanced investments focus partly in equities and partly in fixed returns fetching instruments.
Mutual funds are most often compared to a benchmark such as NASDAQ, NYSE, or Standard & Poor indices.
This selection is an indication that the fund manager has set a bar for the fund.
In other words, the returns fund would be comparable with returns from such indexes.
If the investor is comparing against such indexes, then it is necessary to ensure that comparison is with the chosen benchmark index, and not any other index.