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Mutual Funds: How To Manage Your Risks

Mutual funds are said to be a relatively lower-risk mode of investing in the markets, though of course, they are not entirely risk-free. How do investors work out these risks such that they can select the schemes that best suit them? Shashikant explains.

  • With the advancement of portfolio theory, many new measures of risk have emerged. However, often instead of helping an investor, all these risk measures create more confusion in investors' minds when they are selecting a scheme.
  • Standard deviation is the most basic tool investors can use as the first line of measurement for a portfolio's overall risk-adjusted returns.
  • The Sharpe ratio calculates the excess return a fund has earned for every unit of the risk it is exposed to. The higher the Sharpe ratio, the better the fund's historical risk-adjusted performance.
  • Unlike the Sharpe ratio, the Sortino ratio penalises only downside volatility. Moreover, it also takes into consideration the individual investor return expectation.

Analysing the risk of an asset remains at the heart of any investment decision. This has become more crucial after Harry Markowitz, an American economist who pioneered the work in Modern Portfolio Theory, demonstrated mathematically how diversification reduces risk. Although risk analysis is widely used by institutional investors, it can also be used by retail investors as both share the same goal of maximising their benefit against a given risk.

Risk analysis assumes greater significance while devising a portfolio or selecting a mutual fund scheme because the risk of individual stocks tend to cancel out each other at least partially, if not fully.

With the advancement of portfolio theory, many new measures of risk have emerged. Some of the important ratios that measure the risk of a mutual fund scheme are standard deviation, beta, Sharpe ratio, etc. Often, instead of helping an investor, all these risk measures create more confusion in investors’ minds when they are selecting a scheme. Here, we step in to help you understand what these measures mean so that you can take more informed decisions to select the right funds that suit your risk profile.

Standard deviation is one of the most widely and popularly used measures of risk till date. In pure mathematical terms, this measures the dispersion of the data from its mean. Simply put, the standard deviation is a measure of how much the return of a scheme deviates from its average return.

For example, if a fund has yielded monthly returns of 10, 25 and -15 per cent in the last quarter, it has an average return of 6.67 per cent and a standard deviation of 20 per cent. Compare this with another fund that has given return of 7, 8 and 5 per cent in the same period. This fund too has average returns of 6.67 per cent but with a much lesser standard deviation of 1.5 per cent. What this means is that the returns of the first fund deviate around 20 per cent from its average. Hence, going forward chances are that the fund’s returns will swing more and it will thus be more risky. Against this, the second fund has a standard deviation of just 1.5 per cent, indicating far more stable returns.
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For the 341 equity diversified mutual funds that we analysed, we found that the average standard deviation stands at 18.48 per cent. When we looked at fund houses to find out which of their schemes have the lowest standard deviation, we did not find a substantial difference among them. Tata emerges as the best fund house, with its 16 schemes having an average standard deviation of 16.99 per cent. As per our analysis, the schemes of Reliance are the most risky, with its 20 schemes in this category having an average standard deviation of 20.75 per cent.

Of course, just analysing the standard deviation will not help in deciding whether the scheme is risky or not. This is because it portrays only half the picture, as higher risk might actually have helped the fund to achieve superior returns as well. Therefore, standard deviation should be seen in conjunction with the returns provided by a scheme. Using the Sharpe ratio is what will help you to take a decision based on this factor.

The Sharpe ratio basically examines whether the returns generated from an investment are due to excessive risks taken by a fund manager or due to the right choice of stocks. It calculates the excess returns that a fund has earned for every unit of risk it is exposed to, computed by the excess return divided by the standard deviation. Here, the excess return is defined as the actual return yielded by the scheme minus the risk-free return. Therefore, the higher the Sharpe ratio, the better the fund’s historical risk-adjusted performance.

For example, the ICICI Prudential Banking and Financial Services scheme has generated a return of 35 per cent in the last one year, which was higher than that of ICICI Prudential FMCG, which gave a return of 32 per cent in the same duration. However, if we adjust the returns for their riskiness (calculated by the standard deviation) of the schemes, we find the latter scoring over the former. This is reflected in the Sharpe ratio of ICICI Prudential FMCG (1.34), which is higher than that of ICICI Prudential Banking and Financial Services (0.42). Hence, a rational investor will opt for ICICI Prudential FMCG despite the fact that the scheme gives lesser returns.

For the 341 schemes we considered, the average Sharpe ratio works out to 0.18. Canara Robeco Mutual Fund tops the list as a fund house with a good number of schemes which have the best Sharpe ratio. Seven of its equity diversified schemes have an average Sharpe ratio of 0.41.

Notwithstanding its advantages, one of the shortcomings of the Sharpe ratio is that it uses standard deviation as a denominator (or base) to calculate the excess return generated. This standard deviation includes variations above as well as below the mean. This means that theoretically, returns that spike heavily above the mean are also considered bad. In practice, though, most investors only consider variation below an acceptable level of return as “bad” risk.

To overcome this problem, another ratio called the Sortino ratio is used. This was developed by Dr Frank Sortino of the US-based Pension Research Institute. It uses semi-standard deviation as the base or denominator to calculate the ratio. While the formula is similar to that of the Sharpe ratio, semi-standard deviation includes only those returns that are below a threshold or target return, also known as the minimum acceptable return (MAR). MAR can be the risk-free rate, an index return or any other rate that suits an investor.

Consider a fund which has the following annual returns for the past seven years: 10 per cent, 8 per cent, -15 per cent, 3 per cent, -7 per cent, 10 per cent and 5 per cent. If the MAR is the risk-free rate or 8 per cent (government bond yield), then only returns that are below 8 per cent will be included, i.e. -15 per cent, 3 per cent, -7 per cent and 5 per cent and all other returns are ignored. The semi-standard deviation works out to 8.05 per cent as compared to the normal standard deviation, which is 9.84 per cent. The Sortino ratio also makes an adjustment in the numerator. For calculating excess returns, it considers the MAR instead of the risk-free rate used in the Sharpe ratio.

The major benefit of the Sortino ratio over the Sharpe ratio is that it penalises only downside volatility. Moreover, it also takes into consideration the individual investor return expectations. Therefore, this ratio will vary for different investors depending upon the MAR they choose. Hence, there is no ready reckoner for this ratio.

We suggest that to manage their mutual fund risks, investors should definitely look for standard deviation to start with. However, they should use the Sharpe ratio as the first line of measurement for a portfolio’s overall risk-adjusted returns and the Sortino ratio to get a more realistic and personalised measurement of a scheme’s risk profile to suit their requirements.

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