The Hindu Business Line : Measuring ‘skill’ and ‘earning’ returns

Should you invest in the fund that has given investors a higher return or in the fund that has a better fund manager? Here is how you approach this equation.

V. Pattabhi Ram

As an investor, this one is going to be a tough call. You want to invest Rs 10,000 today in a mutual fund. Where should you invest? Should you invest in the fund that has given investors a higher return? Or should you invest in the fund that has a better fund manager? You might ask “Does not the better performing fund have the better manager?” Well, the answer surprisingly is “No.”

To understand that, you must get to know two more “rates of return”. Let me explain them with an example.

Scene 1: Mr X, Mr Y and Mr Z are the chief investment officers (CIOs) of Fund X, Fund Y and Fund Z, respectively. Each of these funds began on January 1, 2006 with a portfolio of Rs 100 crore. A year later, the value of their portfolio fell by 50 per cent. That is, on January 1, 2007 it stood at Rs 50 crore.

This means that the performance of all three CIOs in the first year has been identical. Now suppose in the second year the portfolio appreciated by 100 per cent. That is, on January 1, 2008 it stood at Rs 100 crore. This means that the performance of all three CIOs the second year has been identical. Hence, across two years, all three of them have performed alike.

Scene 2: Let’s tweak the scene a bit. Suppose at the end of year one, when the market had fallen, investors of Fund X thought that this was the right time to invest further and poured an additional Rs 50 crore into Fund X. So, on January 1, 2007, the Fund holds the initial Rs 50 crore plus the additional Rs 50 crore, adding to Rs 100 crore.

This Rs 100 crore doubles in the second year to touch Rs 200 crore. In essence, a total investment of Rs 150 crore has grown to Rs 200 crore, generating a positive IRR.

Now turn to Fund Y. Suppose at the end of year one, the investors of Fund Y decided to adopt a wait-and-watch attitude. Hence they decided to keep off the market. So on January 1, 2007, the fund holds the initial Rs 50 crore only. This doubles in value in the second year to touch Rs 100 crore. In essence, across two years, a total investment of Rs 100 crore has stagnated at Rs 100 crore, giving a zero IRR

Finally, let’s look at Fund Z. Suppose at the end of year one, the investors of Fund Z felt that it was time to partially exit the market and hence withdrew Rs 25 crore. So on January 1, 2007, the fund, whose value had, like others, depleted to Rs 50 crore, paid Rs 25 crore and has Rs 25 crore only for investment. This Rs 25 crore doubles in value in the second year to touch Rs 50 crore. In essence, a total investment of Rs 75 crore has fallen to Rs 50 crore, generating a negative IRR.

The bottom line is that Fund X has given the best return, Fund Y the second best return and Fund Z the least return. This, however, does not mean that CIO Mr X is more skilled than CIO Mr Y and that CIO Mr Y is more skilled than CIO Mr Z. Remember the performance of the three CIOs is identical because in the first year their value went down by 50 per cent and in the second year it rose by 100 per cent.

Yet their IRRs are different.. This had to do with the intervening inflows and outflows of cash. Additional money came to Fund X at the right time and additional money went out of Fund Z at the wrong time, affecting the overall return. The moral: Fund returns are a function of fund manager’s skills and the time when investors pour money. This brings us to a crucial point. That we must make a distinction between the skills of the manager and the returns earned. The return relevant to measure skill is called time-weighted rate of return. In this case we ignore the intervening inflows and outflows of cash.

We merely look at how Re 1 has progressed over a period of time. In the case of each of the three funds, Re 1 invested in time zero became Re 0.50 in time 1 and ended as Re 1 at end of second year, leading to nil overall return.

The return relevant to measuring returns earned is called rupee-weighted rate of return. It considers the intervening inflows and outflows of cash and is the same as IRR. This in our example was highest in the case of X, second highest in the case of Y and least in the case of Z.

(The author is a Chennai-based chartered accountant.)

More Stories on : Investments | Mutual Funds | Young Investor

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page