Back to Basics. Measuring the risk of a mutual fund

If you are investing in mutual funds, remember that assessing the performance of funds in terms of returns alone is not enough to make your choice. You also need to understand the risks involved with such investments.

You can ascertain the risk of mutual funds, to an extent, by assessing some of the statistical ratios such as standard deviation (SD), beta, Sharpe and Sortino ratios, and drawdown. Most of these ratios can be found in the monthly fund factsheets.

If you would like to compare these ratios of a fund with that of peers, you can refer to the websites of Value Research and Morningstar.

Risk-measuring tools

Standard deviation is one of the commonly used tools to measure the dispersion of a fund’s returns in relation to its mean return. Higher the standard deviation, higher the risk of volatility in returns, and vice-versa.

Take the case of JM Large Cap Fund, which is not a frontrunner in the large-cap fund category in terms of returns. But the scheme records one of the lowest SDs of about three, compared with an average SD of almost six for the category, over a three-year period, as per ACE MF. This means JM Large Cap’s returns in the past three years have been less volatile than most other funds’ in the category.

Generally, equity funds have higher SD than debt funds since the volatility in the equity market is higher than in the debt market. The SD range may also differ from one fund category to another depending on the inherent risk nature of the category. For example, liquid funds, which generally invest in instruments having a short-term tenure and have lower volatility or risk, exhibit lower SD amongst all categories of debt funds.

Further, one can look at another statistical ratio — beta, which helps assess the risk a particular fund takes compared with its benchmark index.

A beta greater than one means the fund is more volatile than the benchmark index.

For example, if a fund portfolio’s beta is 1.1, it is theoretically 10 per cent more volatile than the market.

If the beta is less than one, this means the fund is less volatile than the index. For instance, SBI Small Cap Fund has a beta of 0.84 times against its benchmark index — S&P BSE 250 Small Cap TRI — for the past three-year period. A beta lower than one is considered a positive as the fund’s volatility is lower than its benchmark index’s.

The above two ratios help conservative investors mitigate volatility risks by choosing funds with less SD and beta.

Risk-adjusted returns

If your risk appetite is high and you are not be perturbed by the temporary volatility in funds for long-term returns, you can use some more statistical ratios to identify suitable funds.

Two ratios that can come in handy are Sharpe and Sortino, which measure the ‘risk-adjusted returns’ in mutual funds.

Sharpe ratio measures the extra return a fund has generated over the risk-free rate, per unit of risk (SD).

Therefore, higher the Sharpe ratio, higher the ability of the fund manager to generate higher returns for risk taken.

Sortino ratio, which is a variation of Sharpe ratio, considers only downside deviation risk (downward SD) since the upward deviation is not a risk. This is considered a more precise measure of risk-adjusted return.

The Sharpe and Sortino ratios of almost all segregated (side pocket) schemes calculated for the last three- year period has been negative. This implies that while investing, they took risk which was not commensurate with the returns.

These ratios, when used along with others, can also help conservative investors pick funds that generate higher returns with lower risk.

This can be done by selecting funds with a lower SD and lower beta, but with a higher Sharpe ratio. Take the case of Axis Bluechip, which, for the past three years, has recorded an SD of 5.2 and a beta of 0.7 (one of the lowest in the category) with Sharpe and Sortino ratios of 0.22 (above the category average of 0.14 ) and 0.3 (category average of -0.19), respectively. For the category average, only funds with a seven-year NAV history are considered.

Drawdown risk

Even if you are a high-risk investor, you need to check how a mutual fund has contained the losses in case of a market crash. This can be assessed by drawdown risk, which measures a scheme’s percentage decline between the peak and the subsequent trough during a specific period.

Simply put, this tells you how well a fund protected the capital during worst-case scenarios. For instance, the maximum drawdown for Parag Parikh Flexi Cap from February 1, 2020, to March 31, 2020, was -23.13 per cent vs -27.25 per cent for the category, as per Morningstar. This implies that the fund was better than peers in containing the losses during the market crash in March 2020.

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