Personal Finance

Determining fund risk is easier said than done

B Venkatesh | Updated on June 23, 2019 Published on June 23, 2019

The risk in equity funds is that your investment may not earn you the expected return

A reader pointed to us that the arguments put forth in this column about investment risks were not in line with a mutual fund advertisement, “Risk ko Samajhkar Investment Karna”, being screened during the ongoing Cricket World Cup matches. Accordingly, in this article, we discuss the risk of investing in a mutual fund. We also discuss the issues relating to determining this risk.

Downside risk

The advertisement states that you should understand the risk of a mutual fund and invest accordingly. Now, a risk typically refers to loss of capital, but not when it relates to your mutual fund investment. Why?

Suppose you want to buy a house for ₹1.5 crore. You can make a down-payment and borrow the rest from a bank. But what if you do not have enough money to make a down-payment today? You invest through a systematic investment plan (SIP) in an equity fund and preferably also in a bank recurring deposit to accumulate the down-payment.

Your asset allocation is a function of your monthly savings, the time horizon and the post-tax expected returns on your investments. Assume you expect to earn 10.8 per cent post-tax returns on your equity investments and 4.73 per cent post-tax returns on your recurring deposits.

There is no investment risk on your deposits because the expected and the actual amount you receive at maturity are the same.

So, your portfolio’s downside risk comes from your equity funds. The risk is not just loss of capital, but that your investment may not earn your the expected returns. Why? It is only when your equity fund earns a post-tax return of at least 10.8 per cent every year that you will be able to accumulate the down-payment required to buy your dream house. How can you determine whether the fund will help you meet your life goal?

Investment challenges

Suffice it to understand that you have to calculate your fund’s downside deviation — a measure that captures the return deviation when the fund’s actual return is lower than the expected return.

You then have to arrive at a decision on whether to invest in the fund based on this metric; typically, lower the downside deviation, the better the fund is suited to achieve your goal.

The level of difficulty in determining a fund’s risk is a function of the fund’s portfolio. An index fund has only market risks, whereas an active fund also carries the risk of underperforming its benchmark (or negative alpha). But measuring risk can be a tedious process.

Also, the process assumes that the fund will carry similar risks in the future as it did in the past. This assumption is not always right. For another, you may not have the time to make the risk calculations. So, stating that you have to assess risk before you buy a mutual fund is easier said than done.

That said, you have to invest in equity if you require a return higher than the post-tax return on recurring deposits, to achieve your goal.

Buying an index fund is not difficult because you have to necessarily assume market risk regardless of whether you are able to determine this risk or not. Investing in an active fund can be challenging because of the risk of the fund generating negative alpha. Therefore, determining the fund’s risk is important.

So, invest in an index fund because you must invest in equity. Alternatively, invest in an active fund if you want to. The advertisement is right. You have to assess an active fund’s risk. But that is not easy. And even if you do determine the risk, you could still fall short of achieving your goal.Que Sera Sera.

The writer is founder of Navera Consulting. Send your feedback to [email protected]

Published on June 23, 2019
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