Downside Risk: Selecting Funds, Looking Beyond Returns

Chasing returns may or may not give you better returns. However, if you can manage your risk in investment, you are likely to get better risk-adjusted return

Return remains the single most important criteria used by investors to select funds. There are variants of returns used by investors such as long term, short term and returns in different market cycles to pick the right mutual fund. Whatever the criteria investors choose, returns occupy a dominant role in selecting funds. Nonetheless, now investors are recognising the importance of risk taken to get those returns. One could often earn a higher return by taking a higher risk, but that should not be taken as an indicator of superior performance. Therefore, it becomes imperative that one compares the risk and return of a fund to know exactly where it stands.

For many, containing and managing risk becomes more important than the risk in itself. This will become evident through this article. The Indian equity market represented by the Sensex is still down by 14 .25 per cent year-till-date (June 23, 2020). Nevertheless, once it was down by around 39 per cent from its recent peak in January 2020. It has recovered 36.36 per cent from its recent low of March 23, 2020. If there are two investors, the first one exited the market after the first 20 per cent fall and entered only after the market had recovered 20 per cent. This investor would have been content with a loss of only 10 per cent as compared to 14 per cent by the other investor who remained invested throughout this period.

One of the reasons for such outperformance by the first investor is because he restricted his loss to 20 per cent. Even if he had forgone the first 20 per cent gain while the market was recovering, he suffered lower loss compared to the second investor. This is because protecting from losses in falling markets leaves more capital to grow when the market rises again. Hence, understanding and managing risk should take precedence to returns. It has also been observed that risk containment is highly correlated to the long-term performance of the fund. Moreover, the pain of losing is psychologically about twice as strong as the pleasure of gaining.

Quantifying Downward Risk
Risk is more comprehensive in nature compared to return and the concept of risk is still evolving. There are different ways of measuring the downside risk, which should be used by investors to select the right kind of fund. In the following paragraphs we will highlight some important ways of selecting funds based on downward risk.

Standard Deviation
This is one of the most widely used metrics to measure the risk of investment. It is calculated based on volatility in returns of an asset. Lower the better. For example, if we have two funds giving similar returns, we should go with funds with lower standard deviation.



In the above case, Franklin India Smaller Companies Fund has the lowest annual standard deviation. This means that in any year the fluctuation in return can deviate 40 per cent from its mean. Whereas, other funds like Nippon India Banking Fund can deviate more than 50 per cent in a year from its mean.

Beta
Beta is the measurement of expected return between a fund and the market. Normally we assume that the past is going to represent the future and therefore we use historical return of a fund and its benchmark to determine the beta. In simple terms, beta gives you the expected movement in the fund with respect to its benchmark. If beta is one, it moves in tandem with the benchmark. Again, from a long-term perspective, lower beta is considered to have generated better returns.

Downside Capture Ratio
Downside capture ratio quantifies what percentage of loss, on an average, a fund makes in a falling market. The ‘market’, in this case, is defined by the return of a selected benchmark that should be as closely representing of the fund’s investment universe as possible. In volatile markets, having a lower downside capture ratio is more important than having a higher upside capture ratio of the same magnitude. Mutual funds with lower downside capture ratios tend to exhibit lower overall risk. Investments with lower downside capture ratios can be more attractive to investors due to natural loss aversion and its behavioural consequences.



In the above example, we have taken the benchmark of the respective funds to calculate the downside capture ratio. For example, in case of Nippon India Banking Fund we have taken Nifty Bank as its benchmark. Lower the downside capture ratio the better it is. What this means is that if the market falls by 10 per cent, a fund with downside capture ratio of 0.68 will fall by 6.8 per cent.

Lower Partial Movement
Even though the above models are based on variance as risk measure there has always been much discontent with this proposal. The symmetrical nature of variance calculated in the above (while there is an asymmetry in the returns generated by funds) does not capture the common notion of risk, which is the negative deviation from a reference point. Lower partial moments (LPM) seem to be rectify this and measure risk appropriately. Lower partial moments capture negative deviation from a reference point. That reference point may be the mean or some specified threshold an investor can chose depending upon his opportunity cost. LPM is a set of moments that is used to estimate downside risk. It explains risk perception i.e. the probability of loss. LPM calculates the moments of asset returns that fall below a certain minimum acceptable level or return.



Lower the LPM, lower is the risk. In the above table we have taken gilt as minimum acceptable return or target return to calculate the LPM. Franklin India Smaller Companies Fund has the lowest LPM and this means that the expected shortfall from target return is least in this fund as compared to other funds.

Drawdown
Drawdown concept has become one key type of risk that is now receiving growing exposure by the financial media and analysts because of its relevance to investors. While other technical indicators such as standard deviation, beta, etc. serve as analytical tools that can be used to mathematically quantify and categorize certain characteristics of an investment, drawdown risk is a much more ‘real’ measure of the potential impact that a substantial loss may have on your fund. Drawdown represents the maximum loss taken from a peak in portfolio value to a subsequent low before a new peak in value is achieved.

Drawdown risk becomes more and more relevant to investors as they approach retirement age. In most cases, the drawdown risk increases with a fund’s general risk and volatility. But some funds are able to recoup their losses much more quickly than others, and this can be a key indicator of how well the fund is managed. For example, in case of Franklin India Smaller Companies, the fund had worst drawdown of 51.1 per cent, highest among the funds that we studied. However, it was able to recoup its losses early. Therefore, such funds are better than funds that take ages to recoup their losses.

Expected Shortfall
Expected shortfall attempts to measure the magnitude of the average loss exceeding the traditional mean VaR (value at risk). Expected shortfall has proven to be a reasonable risk predictor for funds. It is defined as the average of all losses which are greater or equal than VaR, i.e. the average loss in the worst (1-p) per cent cases, where p is the confidence level. Said differently, it gives the expected value of an investment in the worst (1-p) per cent of the cases. It will represent the average of outcomes in the worst 5 per cent of the cases if we select 95 per cent of confidence level.



In the above table, Nippon India Banking Fund has the largest expected shortfall and hence it is not a good fund compared to other funds that have lower expected shortfall.

Using Risk to Select Fund
If we analyse the risk statistics of the fund as discussed above, we find that Franklin India Smaller Companies Fund has the best risk statistics and looks less risky. To calculate those matrices we have calculated the daily return of the funds since September 2010. Now, most of you might be wondering about the performance of the funds in the same period. It is no surprise that a fund with lower risk happens to be the best performer.

Therefore, chasing returns may or may not give you better returns. However, if you can manage your risk in investment, you are likely to get better risk-adjusted return.