Investing without measurement is like driving without a dashboard. Whether you’re picking mutual funds, PMS, or AIFs, a few robust statistics can tell you not just how much you earned, but how reliably you earned it. This guide explains the essential performance tools, when to use them, and common pitfalls using clear, Indian market context and investor-friendly language.
Compliance note: Past performance is not indicative of future results. Use these tools as inputs to decision-making, not guarantees.
The Two Pillars: Return and Risk
Return metrics you’ll see most often
- Absolute Return: Simple percentage change over a period.
- CAGR: Smoothed annualised return, best for multi-year, point-to-point comparisons.
- XIRR (Cash-flow adjusted return): Handles irregular investments/redemptions (useful for SIPs, top-ups, and PMS/AIF capital calls).
Risk metrics that complete the picture
- Volatility (Standard Deviation): How widely returns fluctuate.
- Drawdown: Peak-to-trough fall; Max Drawdown focuses on the worst such fall, crucial for real-world pain tolerance.
- Downside Deviation: Volatility is measured only when returns fall below a target (often 0% or risk-free rate).
Risk-Adjusted Performance: Quality of Return
Sharpe Ratio
- What it shows: Excess return per unit of total volatility.
- Formula: (\text{Sharpe}=\frac{R_p – R_f}{\sigma_p})
- Use when: Comparing diversified funds versus a risk-free alternative (e.g., 91-day T-Bills).
- Watch out: Penalises upside and downside equally; may underrate strategies with asymmetric downside protection.
Sortino Ratio
- What it shows: Excess return per unit of downside volatility.
- Formula: (\text{Sortino}=\frac{R_p – R_f}{\text{Downside Deviation}})
- Use when: Capital protection matters or returns are skewed (common in strategies with hedges or option overlays).
Treynor Ratio
- What it shows: Excess return per unit of systematic risk (beta).
- Formula: (\text{Treynor}=\frac{R_p – R_f}{\beta_p})
- Use when: Portfolio is part of a broader diversified allocation; you want to judge compensation for market risk specifically.
Information Ratio (IR)
- What it shows: Excess return over a benchmark per unit of tracking error.
- Formula: (\text{IR}=\frac{R_p – R_b}{\sigma(R_p – R_b)})
- Use when: Evaluating active managers (mutual funds, PMS) against a chosen index (e.g., NIFTY 500 TRI).
- Tip: Pair with Active Share (how different the holdings are from the benchmark) for a full picture of skill versus luck.
Understanding Alpha & Beta
Beta
- Meaning: Sensitivity of your portfolio to market moves (benchmark = 1.0).
- Interpretation:
- Beta 1.2 ≈ is 20% more volatile than the market.
- Low beta can still lose money if the market falls sharply.
- Beta 1.2 ≈ is 20% more volatile than the market.
Alpha
- Meaning: Return not explained by beta (manager skill or factor exposures).
- Caveat: Alpha depends heavily on the right benchmark. An ill-chosen benchmark can create “fake alpha”.
For portfolio structures beyond mutual funds, like PMS and AIFs, benchmark choice is even more critical.
Drawdown-Aware Measures
Maximum Drawdown (MDD)
- Why it matters: Helps estimate potential “stress” during crises.
- Rule of thumb: If an 18–24 month recovery time from a typical drawdown feels unacceptable, you may need to dial down risk.
Calmar Ratio
- Formula: (\text{Calmar}=\frac{\text{Annualised Return}}{|\text{Max Drawdown}|})
- Use when: Comparing strategies that focus on capital preservation or target smoother equity curves.
Capture Ratios & Hit Ratios
Upside/Downside Capture
- What it shows: How a fund behaves in up and down markets relative to its benchmark.
- Ideal but rare: Upside capture >100% with downside capture <100%.
- Use when: Evaluating defensive equity funds, balanced advantage funds, or hedged PMS strategies.
Hit Ratio (Win Rate)
- Meaning: % of periods the strategy beats the benchmark or meets a target return.
- Caution: A high hit ratio with tiny outperformance may still lag materially if losses are large when it “misses.”
Time-Series Tools That Reduce “End-Point Bias”
Rolling Returns
- Why: Avoids the trap of picking a lucky start/end date.
- How to use: Check 1-year/3-year/5-year rolling windows vs. benchmark; observe consistency and dispersion.
- Look for: Lower spread of rolling returns and fewer negative windows for conservative mandates.
Quantiles & Percentiles
- What they add: Sense of best/worst cases (e.g., 10th/50th/90th percentile monthly return).
- Investor use-case: Aligns expectations with reality; better planning for SIP top-ups or STP pacing.
Cash-Flow-Aware Returns You’ll Actually Use
XIRR for SIPs, SWPs, and PMS/AIF Calls
- Why: Real investors invest in tranches, not in one lump sum.
- XIRR shines when:
- You run monthly SIPs in equity funds.
- You deploy capital in stages into PMS/AIF strategies with calls/distributions.
- You run monthly SIPs in equity funds.
- Practical tip: Reconcile XIRR with reported NAV returns to see the investor experience vs. the strategy return.
Picking the Right Benchmark (Don’t Skip This)
- Equity funds/PMS: Use TRI versions (e.g., NIFTY 50 TRI, NIFTY 500 TRI).
- Debt funds: Align duration and credit (e.g., CRISIL index families).
- Multi-asset/dynamic funds: Consider blended benchmarks matching mandate weights.
- AIFs (Cat II/III): Often require custom or factor-based benchmarks; document the rationale and keep it consistent.
Putting It All Together: A Simple Evaluation Framework
- Define the goal: e.g., “Beat NIFTY 500 TRI by 2–3% annualised with <70% downside capture.”
- Select the benchmark: Use TRI; document why.
- Measure returns: CAGR (strategy), XIRR (investor cash-flows).
- Check risk: Volatility, Max Drawdown, Downside Deviation.
- Judge efficiency: Sharpe and Sortino (risk-adjusted quality).
- Assess active skill: Alpha, Beta, Information Ratio, tracking error.
- Test robustness: Rolling returns and capture ratios across markets.
- Review costs & taxes: Expense ratio, PMS/AIF fees, and after-tax outcomes
- Decide and monitor: Set re-evaluation triggers (e.g., IR < 0 for 12 months; drawdown > plan).
Worked Mini-Example (Illustrative)
- Mandate: Large & Midcap mutual fund; benchmark NIFTY LargeMidcap 250 TRI; risk-free = 91-day T-Bill proxy.
- Last 5 years (annualised):
- Fund CAGR: 15.0% | Benchmark: 12.5% | Risk-free: 5.5%
- Volatility (σ): Fund 16% | Benchmark 14%
- Downside Deviation: 10%
- Max Drawdown: −23%
- Tracking Error: 6%
- Fund CAGR: 15.0% | Benchmark: 12.5% | Risk-free: 5.5%
Computed metrics
- Sharpe: (15.0−5.5)/16 ≈ 0.59
- Sortino: (15.0−5.5)/10 ≈ 0.95
- Alpha (indicative): Excess 2.5% with β ≈ 1.05 suggests modest positive alpha (subject to regression).
- Information Ratio: (15.0−12.5)/6 ≈ 0.42
- Calmar: 15.0/23 ≈ 0.65
Interpretation: Good downside management (Sortino > Sharpe) and acceptable tracking efficiency (IR ~0.4). If downside capture <90% and rolling returns show few negative windows, this fund likely fits a core allocation subject to valuation, cost, and mandate discipline.
Special Notes for PMS & AIF Investors
- PMS: Evaluate manager edge via IR, Active Share, sector/factor exposures, and post-fee returns. Consider liquidity and capacity (crowding can erode alpha).
- AIFs: For Cat II (private credit/equity) and Cat III (long/short), volatility may understate risk; emphasise drawdowns, downside deviation, tail risk (e.g., Value at Risk with scenario analysis), and cash-flow timing via XIRR.
Common Pitfalls to Avoid
- End-point bias: Always check rolling returns, not just one period.
- Wrong benchmark: Creates phantom alpha or undue tracking error.
- Ignoring costs/taxes: A 1–2% fee delta compounds massively over time; consider post-tax returns (especially for debt funds and interest from SWPs).
- Volatility ≠ risk: A low-vol strategy with deep, rare drawdowns can be riskier than it looks.
- Data mining: A perfect backtest usually means overfitting. Seek economic logic and live performance.
Quick Glossary (at a glance)
- CAGR: Annualised growth rate; best for multi-year, point-to-point.
- XIRR: Annualised return accounting for all cash flows.
- Sharpe/Sortino/Treynor: Return quality per unit of (total/downside/systematic) risk.
- Alpha/Beta: Skill-adjusted return and market sensitivity.
- Information Ratio: Consistency of active outperformance.
- Max Drawdown/Calmar: Depth of loss and return-to-pain trade-off.
- Capture Ratios: Behaviour in up vs. down markets.
FAQs
1) Which is better, Sharpe or Sortino?
If capital protection matters, Sortino (penalising only downside) is often more informative. Use both for balance.
2) How often should I review performance metrics?
Quarterly for active funds/PMS; monthly if you run sizeable SWPs or leveraged/hedged strategies.
3) Can I rely on a single metric to pick funds?
No. Combine return (CAGR/XIRR), risk (volatility/drawdown), and risk-adjusted measures (Sharpe/Sortino/IR), and always compare to the right benchmark.
4) What’s a “good” Sharpe Ratio?
Contextual. >1.0 is often considered strong in equities, but it depends on regime, costs, and mandate.
5) How do taxes affect these metrics?
Ratios use pre-tax returns by default. For your actual outcome, estimate post-tax returns (especially for interest and short-term gains).
Conclusion
Numbers don’t make decisions; people do. But the right numbers make better decisions easier. Use a consistent toolkit: CAGR/XIRR, volatility & drawdowns, Sharpe/Sortino/Treynor, alpha/beta, IR, and capture ratios anchored to an appropriate benchmark and reviewed on rolling windows. Then layer in costs, taxes, and your risk tolerance. Invest smarter with Equentis Investech.
