Factors Influencing Mutual Fund Returns

There are various factors both internal as well as external that impact the performance of the fund.While it is difficult to take into account the external factors which cannot be predicted, our study reveals how the internal factors affect the funds.

The Popularity of mutual fund investment is increasing exponentially among Indian investors. This can be gauged by the fact that the number of mutual fund investors in India has more than doubled in less than five years. The total number of accounts or folios as per mutual fund parlance as on November 30, 2021 stood at 11.70 crore, while the number of folios under equity, hybrid and solution- oriented schemes, wherein the maximum investment is from the retail segment, stood at about 9.52 crore. In terms of unique investors, the total number of investors may be around 3 crore as a single investor may have different folios.

Most of the increase in the investor base has come recently as more and more investors are added due to better returns offered by mutual funds and high decibel investment awareness programmes run by the industry body. In the short run these may work but the long-term growth of the industry will depend upon the investment experience of the investors. This in turn will depend on how good investors are at selecting the funds and the return expectation from such investment. With over 1,500 schemes to choose from and more being added every month, investors are frequently stumped. As a result, for the sake of convenience, they invest in a fund with the highest trailing returns. This, however, proves to be devastating because past performance does not guarantee future results.

There are various factors both internal as well as external that impact the performance of the fund. External factors such as the macro economic situation, interest rate, inflation as well government policies impact the future returns of mutual funds. A skilled fund manager can reduce the negative impact of any adverse change in the economic situation or augment the returns in case of favourable changes by positioning his portfolio accordingly. External factors are very hard to identify and predict and hence in the following paragraphs we will look at internal factors that determine the returns of the funds over the next one year. We will be studying only equity-dedicated funds as retail investors have higher exposure to such funds

Internal Factors
Factors such as size of fund, expense ratio, exit load, number of holdings, annual turnover ratio and standard deviation of a fund’s net asset value (NAV) are some of the important internal factors that we will look at to gauge if these factors impact the return of the funds. We first ran a regression analysis to understand the factors that influence the returns of the funds for the next one year. What we observed for the 300-odd equity-dedicated funds that we analysed is that these factors only impact 23 per cent of the fund’s returns. Besides, factors such as exit load, turnover ratio and even expense ratio do not play an important role in determining the next one-year return of the funds. These may be impacting long-term returns but not the short-term returns. Our analysis found that standard deviation of a fund for a three-year period, number of holdings and size of the fund play a statistically important role in determining short-term returns. Now, let us understand these individual factors in detail.

AUM of Fund
Our study shows that AUM has a negative relation with the returns. As size of the fund or AUM increases, the returns of the fund tend to decline. One of the reasons for such fall is that as the fund size increases it becomes increasing difficult for a fund manager to find good opportunities to deploy these inflows. '

The graph clearly shows that initially there is positive correla- tion between return and AUM; however, once the fund reaches Rs10,000 crore it shows a negative correlation. There may be some difference in this relation when we consider the category, as large-cap funds may exhibit a different character. However, overall there is a negative relation.

Number of Stocks
To take it on face value, it appears that as the number of stocks increase in a fund, its returns also increase. This looks counter- intuitive as the higher number of stocks means average return as not a single stock will have a larger share on overall returns and it is practically not possible that all the shares of the fund are performing simultaneously. Therefore, we dug further and found that it is quite true for small-cap funds and not for large-cap-dedicated funds or flexi-cap funds.

Standard Deviation
Standard deviation(SD) measures how volatile the fund has been or how much its return wanders around the mean returns. Our study shows that funds with higher three-year standard deviation generate better returns. One of the reasons for such a relationship is that a fund with over-diversification tends to generate lower returns but at the same time such funds are subject to lower volatility captured in the standard deviation of a fund’s NAV. Yes, different periods of standard deviation would have shown different results but we selected three years as it is a standard used by industry experts. Standard deviation does not distinguish good and bad volatility as it blindly takes into account both negative and positive returns from the average return. The graph clearly shows a positive relation between one-year return and three-year standard deviation.

The graph also clearly shows that as standard deviation increases beyond 30, it tends to have negative relation with the one-year return.

MF Performance: More than What Meets the Eye
There are various factors that impact the performance of mutual funds, both internal as well as external. Our study of some of the internal factors such as number of holdings and three-year standard deviation shows a positive correlation while the magnitude of the fund demonstrated a low negative correlation with MF performance. Nonetheless, it only explains about 20 per cent of the returns since a majority of the return is explained by external factors. Hence, as an investor you need to keep track of macroeconomic factors, overall market sentiment and policies both domestic and international to get better returns from your mutual fund investment.