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My colleague Abhishek did an overview of how to look at investment returns (see here, here and here). Let me round out the series with a pet peeve of mine: fees.

Almost all packaged investments (mutual funds, ETFs, etc…) come with a built-in fee structure. Typically, passive ETFs have a lower fee (0.80% for NIFTYBEES, for example) and mutual funds average about 2% annually. So assume that you have a 10 year investment horizon. How do fees impact your total returns?

Lets assume that the market always goes up by 8% annually. So in 10 years, your IRR should be 8%, if you paid no fees. But it falls to 5.84% if you paid even 2% as an Expense Ratio. But the problem is that the market doesn’t go up every year but you will still pay that 2% to the bank.

Before 2008, fund companies estimated that the fees for closed-end funds averaged 6% of an investor’s return, the maximum by law for both types of funds, while the open-ended funds charged 1.75% on average.

The popularity of those high-fee funds back then shows that investors pay little attention to fees when they are amortized over the holding period. When it comes to assent management fees, fore-warned is fore-armed!

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In my intro to calculating returns I had touched upon how to compare returns on different investments, you need to first adjust it for risk. There are three such measures that I consider important: alpha, beta and the Sharpe Ratio.

Alpha measures the ability of an investor to beat the market, thereby generating returns in excess of what might be possible by taking the same amount of risk. Essentially, an investment manager should not only avoid losing money for the client and should make a certain amount of money, but in fact should make more money than the passive strategy of investing in everything equally. Basically, you are paying your mutual fund for the alpha, compared to just buying the Nifty50 ETF.

Beta is similar to correlation (see: The Reliance on Correlation.) An asset has a Beta of zero if its returns change independently of changes in the market’s returns. A positive beta means that the asset’s returns generally follow the market’s returns. By definition, the market itself has a beta of 1.0. A stock whose returns vary more than the market’s returns has a beta whose absolute value is greater than 1. A stock whose returns vary less than the market’s returns has a beta with an absolute value less than 1.

And finally, the Sharpe ratio. The Sharpe ratio tells us whether a portfolio’s returns are due to smart investment decisions or a result of excess risk. This measurement is very useful because although one portfolio or fund can reap higher returns than its peers, it is only a good investment if those higher returns do not come with too much additional risk. The greater a portfolio’s Sharpe ratio, the better its risk-adjusted performance has been. A negative Sharpe ratio indicates that a risk-less asset would perform better than the security being analyzed.

Read More:
Sharpe: http://www.investopedia.com/terms/s/sharperatio.asp#ixzz1lmQd5BEB
Beta: http://en.wikipedia.org/wiki/Beta_(finance)
Alpha: http://en.wikipedia.org/wiki/Alpha_(investment)

Questions? Email me: abhi@stockviz.biz