Mutual funds earn returns but that entails risk. Normally, higher returns entail higher risk and vice versa. There are different ways to measure returns and also different ways to measure risk. Above all, the core point to understand is how to measure the performance of the fund and the fund manager. That will be our focus in this chapter.
Measures Of Returns At A Generic Level
Returns are what you earn on an investment, popularly known as ROI. When you say that you earned a return of 12% in one year on your stock, it means the total return that you earned via capital gains and dividends. Returns are always calculated with reference to your investment outlay but they are also calculated on a point-to-point basis. Here are some important types of returns.
Simple or arithmetic returns
If the NAV of a MF scheme has moved from Rs.10 to Rs.30, then it is a 200% simple return. Simple return has no reference to the time period but only to the change in stock price or fund NAV.
This is a slightly improved calculation of returns, although still not too scientific. For example, a return of 6% over 6 months can be approximated to annual returns of 12%. On the other hand if an investment earns returns of 22% over 2 years, it can be approximated to 11% annualized returns.
Simple returns and annualized returns ignore the time value aspect. That is included in compounded returns. Compounded annual returns also consider the time value of money to give a realistic picture of returns. For example, Rs.100 becoming Rs.142 in 3 years is not 14% annual returns. The compounded annual returns in this case will be 11.24% because (100 x 1.124 x 1.124 x 1.124) = Rs.142. Compounded returns are more realistic as the time value of money is also factored in. The compounded return can be worked with a simple excel sheet and is also known as compounded annual growth rate (CAGR).
SEBI Norms Regarding Representation Of Returns By Mutual Funds In India
Till the early 2000s there was no standardization or code of conduct on how to present mutual fund returns. Funds used to annualize weekly returns and advertise, which was a gross misrepresentation. To avoid such misrepresentation, SEBI has given clear guidelines for representing fund returns. Here are the highlights.
- Mutual funds are not permitted to promise or assure any returns in any equity, debt, hybrid or even liquid schemes.
- In specific cases like MIPs or FMPs, the funds are allowed to represent indicative returns but then it should be clearly mentioned that returns are indicative only
- Assured return schemes are only permitted in the event there is a guarantor and the name of the guarantor is mentioned in the offer document. Such guarantor will have to make good the loss if the return falls below the cut-off mark.
- Returns cannot be annualized when the period is shorter. In case of longer periods, the annual returns must only be presented in the CAGR format to give a clear picture.
- All return announcements must be accompanied by risk factors which the investor should be aware of to avoid mis-selling.
Types Of Macro Risks In Mutual Fund Schemes
We shall look at scheme specific risk in detail later in this chapter, but what is covered here is the broad risk or the macro risk that mutual funds run. Here are some key risks.
Portfolio risk arises in mutual funds because even with the best of expertise and intentions, calls and views can go wrong. These may be factors beyond the control of the fund. The best way the fund manager can handle is by managing the portfolio risk through rigorous research, constant information flows, market intelligence and diversification.
When investments are liquid, there is a transparent market benchmark. Liquid investments can be sold easily without price impact. SEBI has laid down criteria to identify illiquid investments, and also set a ceiling to the proportion of such illiquid investments in the net assets of a scheme. It is to overcome such eventualities that mutual fund schemes maintain a certain proportion of their assets in liquid form.
Liabilities in the scheme
The portfolio, as we saw, is subject to market risk. The outside liabilities need to be paid by a scheme, irrespective of the performance of the fund. Therefore, outside liabilities add to the risk in a mutual fund scheme. Some outside liabilities are part of the business. For example, when a scheme purchases an investment, it is liable to pay for it. Until the payment is made, it will be a liability of the scheme.
How SEBI limits risk in mutual funds
SEBI has permitted some macro level checks so that the risk of the fund does not get magnified beyond a point.
- A mutual fund scheme cannot borrow more than 20% of its net assets
- The borrowing cannot be for more than 6 months
- The borrowing is permitted only to meet the cash flow needs of investor servicing like dividend payments or re-purchase payments.
Portfolio Risks And Mutual Fund Vulnerability
It is a myth that only equity funds are risky and debt funds are not. Debt funds carry their own set of risks. In 2018 and 2019 it is debt funds that have run into trouble due to over exposure to a set of stressed business groups. Here are some specific risks.
Risks in Equity Funds
- The real economy goes through cycles and these cycles of boom and bust have their impact on equity markets and therefore on Equity fund valuations too.
- Equity markets are known to be erratic and volatile in the short term. This volatility gets transmitted to the performance of equity funds
- There is no assurance of returns in an equity fund and they can vary from strongly positive returns to deeply negative returns in another year
- Then there are risks that are unique to specific portfolios and types of funds.
- Sector funds suffer from concentration risk while diversified funds suffer from multiple sectoral risks getting transmitted to their performance.
- Thematic funds can be vulnerable to factors like infrastructure spending, consumption spending, interest rates etc.
- Mid cap funds invest in less liquid and less researched stocks in the market. Such stocks also tend to be very vulnerable to market cycles and they are more vulnerable to liquidity conditions in the market.
- Contra funds take positions that are contrary to the market and they rely too much on the judgement of the fund manager. At the same time, dividend yield funds tend to be boring and don’t give the returns of growth funds.
- Growth oriented funds can be quite inhibiting in a difficult market whereas in the case of value funds, there is huge risk of getting caught in the value trap. More so, since information on many stocks is hard to come by.
- There are also conservative versus aggressive funds. While conservative funds are largely passive in their approach, aggressive funds run the risk of high portfolio turnover leading to higher costs and loss of opportunities.
Risks in Debt Funds
Debt funds are an extremely heterogeneous class. It extends from liquid funds at the short end to G-Sec funds in the long end to credit risk funds for higher returns. They all cannot be painted with the same brush. Here are some of risks in debt funds.
- Debt securities are repayable on maturity so they are a commitment. Hence cash flows of the issuer are always a major risk for the debt fund.
- While the interest on debt appears to be assured, debt paper is vulnerable to interest rate movements. Your debt funds can also give negative returns if yields rise.
- Debt fund returns are much lower than equity funds and hence debt fund managers are vulnerable to wrong calls on the interest rate movements.
- There is a major liquidity risk because the debt markets, other than the G-Sec market, are not really liquid and that is a major cost.
- In 2018, SEBI standardized debt funds mandatorily fewer than 16 categories and each AMC could only have one fund per category to avoid confusion in investor minds.
Risk in Hybrid Funds
Hybrid funds invest in a mix of debt and equity. It is rare for both debt and equity markets to fare poorly at the same time. Since the performance of the scheme is linked to the performance of these two distinct asset classes, the risk in the scheme is reduced through diversification across asset classes. Some hybrid schemes offer significant asset allocation flexibility to the fund manager. They can switch a large part of their portfolio between debt and equity depending on their view on the respective markets; making them risky.
Risks in other classes of funds
Other funds, apart from the core equity, debt and hybrid funds also carry different levels of risk. Let us look at some of the key risks.
- Gold funds are vulnerable to international price movements and the exchange rates. Gold demand and supply and specific factors like central bank buying, ETF buying all have a deep impact on gold fund performance.
- Real Estate Funds are based on subjective valuation methodologies and that makes them opaque and risky. Transaction costs, in the form of stamp duty, registration fees, etc. are notoriously high. It also carries a huge regulatory risk.
Different Measures Of Risk
Risk in mutual fund arises from the fluctuations in the NAV of the fund. The fluctuation or variation may be on the higher or lower side. Both are considered to be risky. Here are some common measures of risk in the case of mutual funds.
Variance measures the fluctuation in periodic returns of a scheme, as compared to its own average return. To take a simple example if Fund Alpha gave returns of 11% and 10% in the last two years and Fund Beta gave 19% and 2%, the net effect is almost the same but Fund Beta has a much higher variance making it extremely risky. Variance as a measure of risk is relevant for both debt and equity schemes.
Standard deviation is equal to the square root of variance. Standard deviation is important because it represents total risk in an investment. A high standard deviation indicates greater volatility in the returns and greater risk. If the Beta effect is taken out of standard deviation, you get the unsystematic risk of the fund.
Beta or systematic risk
Beta is a measure of systematic risk, which is the risk that cannot be diversified away. Beta risk typically arises out of factors like inflation, interest rates, political risks etc. This arises primarily from macro-economic and political factors.
Non-systematic risk is unique to a company and hence the portfolio can diversify the risk by adding low correlation assets to the portfolio. This includes specific risks arising out of change in management, product obsolescence, new product launches, disruptive technologies, labour strife etc.
Modified Duration (MD)
MD measures the sensitivity of value of a debt security to changes in interest rates. Higher the modified duration, higher the interest rate risk in a debt portfolio. Debt fund managers rely on modified duration as a better measure of sensitivity to interest rate changes and also for avoiding maturity mismatches between their assets and liabilities.
While G-Sec funds do not carry credit risk, the credit rating profile indicates the credit or default risk in a debt fund portfolio, especially if it consists of private sector debt. Higher the credit rating lower is the default risk.
Measuring Fund Manager
There are different ways of measuring the performance of a fund manager. Here are some popular measures and their relative merits.
Absolute & Relative Returns
Absolute returns are point-to-point returns with reference to the amount invested. Relative returns are based on benchmarks. For example 14% returns on the equity fund is great but it is not good if the Nifty has given 15% returns. Funds are normally judged by the extent to which they outperform the benchmark indices. Relative returns are about returns of a fund with respect to the benchmark indices. Here selection of the appropriate index is critical.
Risk-adjusted Returns – Sharpe Ratio
Which is better; 14% return with 10% risk or 15% returns with 40% risk. Obviously the first one is better and that is what risk adjustment of returns is all about. Sharpe Ratio uses Standard Deviation (total risk) as a measure of risk. Sharpe Ratio is calculated as
(Rs-Rf) ÷ Standard Deviation
Sharpe works best when the portfolio is not properly diversified. Most Indian funds use and report this measure in their fund fact sheets.
Risk-adjusted Returns – Treynor Ratio
Like Sharpe Ratio, Treynor Ratio is also a risk premium per unit of risk. The only difference is that Treynor uses Beta instead of standard deviation as the denominator. Treynor Ratio can be calculated as:
(Rs-Rf) ÷ Beta
This approach is more suitable for well diversified portfolios. Since that becomes a subjective assessment, Indian funds prefer to use Sharpe over Treynor.
Risk-adjusted Returns – Treynor Alpha
Non-index funds are expected to earn a minimum return that accounts for a premium over the index returns depending on the risk of the fund. Anything above that is Alpha. In other words, the difference between a scheme’s actual return and its optimal return is its Alpha.
Tracking error is best suited for index funds and measures how well the fund returns mirrors the index. Any deviation is a negative point. Lower the tracking error, the better it is for an index fund.