How good is your fund to protect downside risk

The conventional wisdom of investment says that you buy the right fund and hold it for the long-term. The only problem with such insight is that events like sub-prime crisis can completely wipe out years of gains. Therefore, before choosing a fund for investment knowing how much it shields you from downside risk becomes utmost important. Downside protection does not mean your fund will never give you a negative return. What it means is that the fall in the value of the fund is less compared to benchmark or index in a given period. Hence, if Sensex is down by 25 per cent and your fund is down by just 12 or 8 per cent, it means your downside is protected in the fund.

One of the ratios that help you judge a fund’s ability to provide downward protection is Sortino ratio. While the Sharpe ratio measures risk-reward potential of a fund, that does not differentiate between upward and downward volatility, Sortino ratio focuses specifically on downside volatility. It shows how often the fund has dipped below its average returns during the period.

The numerator of the Sortino ratio is calculated as fund's excess returns on a monthly basis over a risk-free rate of return such as the yield on long-term government securities. For the denominator, Sortino ratio uses a different measure. It captures downside deviations of the fund and ignores the fund's returns if they're above the fund's mean portfolio return. By penalizing only an investment's undesirable volatility, the Sortino ratio expresses a fund's excess return relative to its downside risk.

However, a fund's Sortino ratio should be assessed in comparison with another fund, index, or category because it is not meaningful when viewed in isolation. Moreover, investors should assess a fund's Sortino ratio considering their investment horizon and risk tolerance in managing their portfolios.

In addition to using Sortino ratio to understand how much your fund gives you downside protection, there is another type of fund known as dynamic equity mutual fund that tries to maximise downside protection. The dynamic mutual fund switches fund between different kind of assets classes. The fund is specially designed to switch between equities and debt depending upon market conditions. In case of rising market, the more funds are invested in equities and less in debt and cash. In cases where the market is falling, more funds are invested in debt and cash, and fewer funds are put in equities. Even hybrid funds do the same, but they cannot rapidly switch between assets class.

These funds aim to normally invest in equity but can react quickly to a negative market by moving 100 per cent of their assets into money market instruments, fixed income securities and derivatives with an aim to limit the downside risk.

In long run, it always pays to invest in a fund that performs better during market fall, even though this means the fund has failed to beat the benchmark during a market rally.