97% Annual Returns : Mutual Funds Selection - Statistical Analysis beyond Historical Returns

Below article is the 3rd in my series of articles on how I built up a portfolio giving 97% compounded annual returns (in stocks portfolio) and 37% annual returns in MFs. You can read first article by clicking on 97% Annual Returns : My Learning and Practices and second article can be accessed by clicking on 97% Annual Returns : Implementation.  

One of the most sure-shot method of convincing clients about investing in Mutual Funds (MF) employed by Wealth Managers in India is showing them Historical Returns. Typically clients are aware of 6-8% returns of Fixed Deposits, while Mutual Funds historically have returns of more than 12% and hence looks tempting. Being a Wealth Manager myself I can swear on the fact that its the most effective tool of closing the deal positively. 

I myself have been using the same methodology for selecting which MFs to invest into. It is the easiest way to select MF, just download historical data , have it in ascending order and select the top ones in the list.  

But the real change came when I started revising my concepts of Statistical Analysis learnt during my Portfolio Analysis course at IIT Delhi. Going through standard deviation , mean , Sharpe Ratio etc., I realized that same can be used to select MFs whose historical returns are not only a function of market returns and fluke but because of good investment strategy of the Fund Manager. It also makes future performance of the MFs more predictable. 

These ratios can not only be used for MF selection, but for overall portfolio as well. So before going further into the Ratios, I will dwell into some basics of the statistics beforehand.

• Standard Deviation - It is the parameter by which you can measure the propensity of any data to 'deviate' from the 'mean' i.e. average value. Hence , you can say it is a measure of 'Risk' of the MF or portfolio. 
• Correlation - It is a measure of how much two parameters are 'linked' to each other. Simply put how would movement in one parameter effect values of other parameter.  

Now lets explore the ratios one by one - 

1. Alpha - It is the difference between the returns of the portfolio or MF and the respective benchmark. E.g. If 3 years returns of Reliance Small Cap Fund is 23% and 3 years returns of its respective benchmark (i.e. S&P BSE Small Cap Index) is 15%, Alpha will be 23%-15% = 8%.
2. Beta - It is a measure of 'correlation' between a MF and its respective benchmark. In layman terms,
• A Beta value of '1' signifies that MF will move perfectly in tandem with the benchmark. So if benchmark moves up by 15%, MF will also move up by 15%.
• Similarly a Beta value of less than '1' means that MF is less volatile than the benchmark. So MF will move less 'up' and 'down' than the benchmark. 
• A Beta value of more than '1' means that MF will move more 'up' and 'down' than the benchmark. 
3. Sharpe Ratio - Sharpe Ratio is a measure of 'Returns' and 'Risk'. Numerator is the difference between expected returns of the MF and Risk Free returns like returns of US treasury bonds, while denominator is a measure of Risk i.e. 'overall' standard deviation of the MF. As anybody will tell, we will like 'Risk' to be as less as possible and Returns to be maximum, hence a higher value of Sharpe Ratio is always desirable. 
   
4. Sortino Ratio - It is a better version of Sharpe Ratio, while Sharpe Ratio takes into account  'overall' part of standard deviation, Sortino takes into account only 'negative' part of standard deviation. A parameter (in this case Returns) can 'deviate' in both 'positive' (i.e. higher returns than the 'mean' value) and 'negative' (i.e. lower returns than the 'mean' value) direction. While negative deviation is harmful to the investor, positive deviation only increases investor returns. So Sortino takes into account only standard deviation of 'negative' returns in the denominator. 
5. Expense Ratio -  It is the %age of the fund value charged by the Fund Manager as his expenses. In India it is capped at 2.5% per year by the market regulator SEBI. Needless to say lower is the expense ratio, better the MF is. 

Stay tuned to learn about stock selection in my next article. Till then you can read about my multibagger which gave me more than 300% annual returns Avanti Feeds : A Comprehensive Stock Analysis.