Should investors worry about P/E ratio of mutual funds?

Price to earnings or P/E ratio is an important parameter in the world of stocks.

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Price to earnings or P/E ratio is an important parameter in the world of stocks. Some pundits believe that it is time mutual fund investors start taking the P/E ratio of mutual funds seriously. The ratio tells you the price you pay for one unit of earnings of a stock. What does it tell you about a mutual fund scheme?

Before answering the question, we need to understand what is the P/E of a mutual fund scheme and how is it calculated? P/E of a mutual fund is like how you calculate P/E of an index. It is weighted average number of the P/E of stocks in a scheme’s portfolio.

Mutual fund experts believe P/E of a mutual fund does not convey as much as P/E of a stock. It only coveys about the kind of stocks in a portfolio. Investors should not rely on it to make their investment decisions, say experts.

“P/E of a mutual fund indicates the investment approach followed by a mutual fund scheme. It tells you whether the fund follows a growth style of investing or value investing,” says Himanshu Srivastava, Senior Analyst Manager Research, Morningstar. “This cannot become your sole deciding factor,” he adds.

Growth investment approach focuses on capital appreciation. Those following this strategy do not care even if the stock is expensive as they are confident about the strong earnings growth of the company. Value investors, on the other, look for quality stocks which are undervalued and have the potential to appreciate.

Here is an example of how it works. We looked at the past one-year returns of largecap schemes. Interestingly, out of 32 large cap schemes, only two gave positive returns. Axis Bluechip Fund gave 5.59 per cent while the category average return was -4.42 per cent. When we went through the P/E ratio of these schemes, we found Axis Bluechip has a ratio of 43.83 per cent as against the category average of 31.46 per cent.

This simply shows that the outperforming scheme is following the growth strategy and has a comparatively higher exposure to the stocks with higher P/E than its peers. But this does not tell you anything about whether the fund is good to invest or not.

You can also compare the P/E of a scheme to its benchmark to understand better about its style of investing.

Mutual fund experts say selection of a mutual fund is based on lot of factors other than the P/E of the scheme.

“The selection of a mutual fund is based on other more important factors, including investor’s risk appetite, time horizon, scheme’s track record, whether the scheme is consistently following a particular strategy articulated in the SID, quality and consistency of the portfolio across the market cycles. These will play bigger role in decision making,” says Sachin Relekar, Fund Manager – Equity, LIC Mutual Fund.

“However, a retail investor, if is able to comprehend, can look at P/E of the scheme in conjunction with other more important factors to know the scheme better,” Relekar adds.
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