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Understanding how to measure mutual fund risk

Most investors ignore the risk factors involved in mutual fund before investing. This is a behavioural anomaly among investors which shows that they don’t understand the risk return relationship. Financial expert Manikaran Singal explains ratios that measures volatility to enable investors to take better investment decision.

October 24, 2013 / 11:48 IST
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Most investors aim at generating maximum returns and with this mindset they tend to ignore the disclaimer which Mutual funds highlight ‘Mutual funds are subject to market risk. Read the offer document carefully before investing’. This is a behavioural anomaly among investors which shows that investors don’t understand the risk return relationship. They have a tendency to run towards return, without considering risk. Yes, this is true! Generally it is said that people are risk averse, but it would be more apt to say that they are more inclined towards return. This can be seen in the behaviour of people investing more in stocks when the market is moving higher and staying away when it is down. The basic risk in equity has always remained same, but in both the cases the target is to get more returns. This can also be related to the preference for instant gratification.

One should accept the volatility risk while looking for good returns and select mutual funds after having a balanced view on both the parameters. In fact it is also good to have a clear idea of one’s own personal risk profile, which also helps in zeroing in on a suitable product. Checking returns is quite easy as they are available easily through various resources. For measuring risk associated with the product there are various ratios which one may look at before selecting a mutual fund. Do note that these ratios will depict nothing in isolation unless they are compared with the similar funds. Equity Mutual funds: In equity mutual funds, risk gets measured with standard deviation and beta. Let’s understand these two parameters in detail. Standard Deviation: This measure tells how much the return of a particular fund deviates from its average return or mean. These deviations show how volatile the fund is. In simple terms higher the standard deviation, higher will be the risk. For example a fund with standard deviation of 10%, will have a tendency to deviate 10% from its average return.  Following are the standard deviation figures of three pure large cap funds (as on 9th July’13):

FundsStandard deviation
DSP Blackrock Top 10017.12
ICICI Prudential Focussed Bluechip Equity16.8
Franklin India Bluechip15.7
        Looking at the risk associated with a particular fund, viewing its past returns and comparing it to the expected return in your mind, it would be easy for you to decide which fund to choose. You may choose a fund with higher standard deviation, if your expectation of return in that particular fund is higher and it suits your risk profile. Beta: Beta tells how sensitive the fund is towards the market movement. In other words, it shows the sensitivity of mutual fund portfolio towards market. Beta is always benchmarked to 1. This means that if the fund’s beta is 0.80 it is less sensitive to benchmark movement or if it is 1.20 it is more sensitive. In other words in the former case with every rise in market by 1, fund will rise 0.80 and if there’s fall, fund will fall less i.e 0.80. Here, market does not mean only Sensex or Nifty, it is actually the particular benchmark index for that particular scheme. If you use beta as your risk tracking parameter then the benchmark of funds in comparison should be same. Below are the benchmarks and betas (as on 9th July’13) of the three funds mentioned above.

Mutual fundBetaBenchmark
DSP BlackRock Top 1000.87S&P BSE 100
Franklin India Bluechip0.81S&P Sensex
ICICI Prudential Focussed Bluechip0.87CNX Nifty
        This shows that none of the above funds are comparable as far as BETA is concerned as the benchmark of all the funds is different. While looking at beta, one should also be sure that how much of the portfolio of Mutual fund is actually representing the benchmark. If the portfolio represents less than 80% (0.80) of benchmark, then beta loses its significance. This correlation can be seen from ratio called R2. Higher the R2, higher the correlation of portfolio with the benchmark and more will be the relevance of beta. Once you have accounted for standard deviation in your selection, you may also look at beta in comparison with their benchmark, to filter your research. Debt Mutual funds: Besides returns sensitivity, debt mutual funds have two more risks which are credit/default risk and interest rate risk. Thus in debt mutual funds one has to look at very specific parameters to figure out these risks, which are as below: Credit Ratings: One should be very clear on the credit rating of the portfolio which the fund will invest in. Different debt instruments get rated by rating agencies like CRISIL, ICRA and CARE.  Higher the rating (AAA, P1+) higher will be the safety of portfolio. Modified duration: Modified duration is a kind of BETA for debt mutual funds. It tells the sensitivity of fund towards the interest rate movement of the underlying portfolio. Higher the modified duration, higher will be the sensitivity and thus volatility. Say for example if the modified duration of a fund is 5 years, then every 1% of rise in interest rates of the respective portfolio may lead to 5% fall in the funds returns. Thus in falling interest rate scenario, investors generally prefer longer duration funds as chances of  return is higher and in rising scenario one goes with shorter duration funds. Things are easy to manage, if you have clear goals in your mind. This will guide as to which asset class to choose and with what parameters. - Manikaran Singal
(The author is Certified Financial Planner and a member of The Financial Planners’ Guild, India (FPGI). FPGI is an association of Practicing Certified Financial Planners to create awareness about Financial Planning among the public, promote professional excellence and ensure high quality practice standards.)
first published: Jul 12, 2013 04:40 pm

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