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Why Comparing Returns to Risk Is More Meaningful - Outside View by PersonalFN

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Why Comparing Returns to Risk Is More Meaningful
Jul 16, 2016

Rob, a 27-year-old Media professional, landed for the first time in the financial space. He is an alien to this world and is fascinated with specimens like mutual fund, hedge fund, equity stocks, and insurance. He feels some connection with mutual funds and wants to know a bit more about them. He tries to grasp their language and culture but feels a little lost.

We will familiarise Rob to this world of mutual funds and introduce him to Risks and Risk-adjusted returns.

There is an element of risk in every step you take in life; isn't there? But many of you will appreciate that unless a calculated risk is taken, meaningful outcome cannot be derived.

Likewise investing in market linked products involves risk. If you win, you will gain; but if you lose, you will turn wise.

While investing in mutual funds, every investment decision that your fund managers take involves a degree of risk. The investment bets may generate phenomenal returns, while sometimes be disappointing. Hence it is important to understand and appreciate the risk your fund manager takes. Technically, there are number of risks such as market risks, price risk, default risk, interest risks, amongst others that your fund manager encounters while building a portfolio.

And as an investor you can assess the risk exposure that he/she's been taking and that may be tagged even going forward. There are various measures used to calculate risks. Let us introduce and acquaint you with each of them...

  1. Standard Deviation

    Risk is a result or outcome which is other than what is / was expected. Thus what's other than what was expected is a 'deviation', and in portfolio management parlance it's referred to as 'Standard Deviation'.

    SD is used as measure to evaluate risk. It denotes how much a fund's return would deviate from the mean or average. In simple terms, it depicts how risky the fund is. Higher the SD, riskier the fund is.

    Suppose Fund A has SD of 4% and Fund B has SD of 7%, it means fund B is more volatile compared to fund A.

    Let's suppose a fund's standard deviation is 4% and an average rate of return is 10% per year. Most of the time, we can expect that the fund will generate future returns in the range of 6% to 14% (10%-4%=6% or 10%+4%=14%). So this number will give you an idea of the range of returns the fund will generate in future. It studies the fund's performance deviation.

    So you can use this measure to compare your risk appetite and the level of risk your fund manager takes while managing the portfolio.

  2. Sharpe Ratio

    Named after William F. Sharpe, this ratio denotes the risk-adjusted returns, as it takes into consideration the risk involved to clock returns. It measures how much return you can expect over and above a certain risk-free rate (for example, the bank deposit rate), for every unit of risk (i.e. SD) of the scheme. Statistically Sharpe Ratio is calculated as:

    Thus this ratio helps to recognise if the fund is justifying the risk taken. Higher the Sharpe Ratio, higher you are compensated for the risk taken by the fund.

    For instance, if fund A and fund B generates annual return of 12% and 14% respectively and their standard deviation is 5% and 7% respectively; with a risk-free rate of 4%, the Sharpe Ratio will be 1.6% for fund A while for fund B, 1.4%. It denotes that Fund B justifies the risk taken vide higher risk-adjusted returns compared to Fund A. Hence this ratio can be used as a checkpoint to make sure a fund's returns are in line with its risk level.

  3. Sortino Ratio

    Named after Frank A. Sortino, this ratio evolved from Sharpe Ratio and is a little more advanced. It also measures risk-adjusted returns. But unlike Sharpe Ratio (which considers good as well as the bad volatility), Sortino Ratio considers only bad volatility. Thus, it considers the negative deviation only.

    Suppose Fund A has been generating average return of 10%, 9%, 3%, 2%, -3%, -2% and 4% for seven years respectively and if risk free rate is 4%, the returns that are below 4% will be included. In this case -3%, -2%, 3%, and 2% returns will be considered as deviation from rest all will be ignored. Through this measure of evaluation, the fund is expected to deliver at least threshold return that investors expect.

    Hence under this ratio, the fund manager is not punished for the volatility, as long as the fund manager can clock returns you as an investor expect. You may be wondering if this is also a risk-adjusted return calculator then which ratio must be considered. Well, Sharpe Ratio can be used for funds which are less volatile because Sortino will not have many data points to calculate downside deviation.

  4. Roy's Safety First (SF) Ratio

    The Safety first ratio (SFR) is much more than a formula. It is a technique which helps an investor select one portfolio over the other based on the set threshold limit. While investing in any portfolio you always have a threshold of return below which you wish to not go.

    An optimal portfolio will be one which minimizes the probability that the portfolio's returns will fall below the threshold level. Statically this ratio is calculated as:

    In other words, it will depict the probability of your portfolio generating returns below the limit set by you. In this way, you select the safest portfolio and are rest assured ...and anything above the threshold is investors delight.

  5. Information Ratio

    Information Ratio measure portfolio returns above the returns of a benchmark along with the volatility on the way. You may have read about how a fund has been beating its benchmark index over a certain period of time. Information ratio is one such measure which depicts your fund manager's ability to generate consistent returns relative to its benchmark. Statistically this ratio is calculated as:

    Tracking Error is the standard deviation of the difference between fund return and index return. It is useful in comparing mutual fund houses with similar management styles.

    Higher the IR, more consistent is the fund manager in generating returns relative to the benchmark. It also depicts a fund manager who has outshined other fund managers.

To Sum up:

The returns that mutual fund schemes clock is to be weighed vis-a-vis the risk taken. And as seen above, there are various ways you can evaluate the performance before you zero down mutual fund schemes for your investment portfolio.

Understanding these risk ratios will help you critically assess the better mutual fund scheme / investment channel for you. It is important to keep a check on how the fund manager is managing risk in the race to generate better returns. Hence the next time you get lured only by Returns, do re-visit the Risk taken by the mutual fund house.

PersonalFN is a Mumbai based personal finance firm offering Financial Planning and Mutual Fund Research services.


The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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