Is your fund worth the risk?
Apr 30, 2003

Author: PersonalFN Content & Research Team

As many investors will testify, investing in mutual funds can be a risky affair. This is because unlike a bank fixed deposit (FD) or a bond, where you are assured the principal amount as well as the interest, in a mutual fund you are assured neither. Therefore, it's important that you evaluate the risk profile of the fund before investing in it.

Ideally, the risk involved in any investment should never be looked at in isolation. It should be compared with the return one has made (or can make) on that investment. To cite an example with fixed deposits (FDs), a higher interest rate attracts greater investor interest. However, that is not without its pitfalls, because when an FD offers a (relatively) higher interest rate, its credit rating is also lower. For e.g., HDFC FD, the most respected name in the FD world with a AAA credit rating, also has the lowest rate of interest 6.25% (cumulative option for 1 year). On the other hand, obscure names like Futura Polyesters and Surya Pharma offer interest rates in excess of over 10% (for the same option). This is because these companies are unrated and carry a higher risk profile and seek to reward the investor with a higher rate of interest. This is a thumb rule of investment higher risk translates into higher reward.

This investment rule must also apply to mutual funds, the operative word is must, but it does not always. The challenge is to latch on to a mutual fund that gives a return at equal or lower risk. Once you have mastered this, you are unlikely to be taken by surprise by any fund manager, because you already know what you are getting into at the time of investment.

One of the important and widely used parameters to gauge the risk-return trade-off is the Sharpe Ratio. The ratio is a measure developed to calculate risk-adjusted returns. The Sharpe Ratio is the difference between the annualised return (Ri) of the scheme and the average risk-free return (Rf), normally the bank fixed deposit rate. This is then divided by the Standard Deviation.

Sharpe Ratio = (Ri Rf)/SD

Therefore, higher the magnitude of the Sharpe Ratio, higher is the performance rating of the fund.

Keep an eye on the risk profile

Diversified Equity Funds	NAV (Rs)	6-Mth	1-Yr	3-Yr	5-Yr	Incep	SR
RELIANCE VISION G	27.3	17.1%	28.4%	11.2%	15.7%	14.0%	0.35
RELIANCE GROWTH G	29.8	11.7%	13.0%	-0.3%	16.6%	15.3%	0.21
FRANKLIN PRIMA FUND G	29.9	14.6%	9.6%	7.7%	20.8%	12.4%	0.20
ZURICH I EQUITY G	23.2	18.2%	4.8%	3.5%	23.0%	11.4%	0.14
FRANKLIN I BLUECHIP G	22.8	15.1%	4.8%	-1.4%	19.6%	20.6%	0.03
ZURICH I TOP 200 G	17.1	16.0%	4.0%	-	-	2.5%	0.09
SUNDARAM GROWTH G	12.2	9.1%	-1.2%	-6.0%	8.4%	9.8%	0.02
TEMPLETON GROWTH G	12.6	9.1%	-2.7%	-0.2%	6.3%	5.3%	0.01
HDFC GROWTH G	8.2	6.5%	-5.8%	-	-	-7.3%	0.02
ALLIANCE EQUITY G	24.6	8.8%	-10.4%	-13.4%	-	20.3%	-0.02
BIRLA ADVANTAGE G	23.2	5.1%	-13.1%	-18.7%	15.3%	14.4%	-0.10
IDBI-PRINCIPAL INDEX G	7.2	-0.2%	-14.3%	-11.7%	-	-9.0%	-0.13

(NAVs as on April 25, ˜03. Growth 1-Yr is annualized. SR is a number)

We have taken a sample of some of the leading diversified equity funds in the country today. Keep an eye on the NAV returns and the Sharpe Ratio (SR). If you have understood how Sharpe Ratio works you would have identified Reliance Growth, Reliance Vision, Franklin Prima Fund, Zurich Equity, Franklin Bluechip as the leading equity funds as they have posted higher growth with relatively lower risk, which gives them a higher Sharpe Ratio (remember higher is better). On the other hand, Birla Advantage and Alliance Equity have been the bad apples. Birla Advantage despite a 15.3% growth over 5 years still has 0.10 Sharpe Ratio, which indicates that the risk taken for that growth was unusually high.

When you are selecting a fund, you need to keep an eye on what you are getting (in terms of returns) and the price you are paying for it (in terms of risk). Evaluate this across funds and peers. Then evaluate your own risk profile and pick that is most compatible with your investment profile.

For instance, if you are older (over 40 years), then you do not have the appetite for a high risk/return fund. So you need to select a fund with a lower risk profile, which implies lower returns. If you are a younger (about 30 years), you can consider investing in a high risk fund, that has clocked higher growth during the good times.

However, the best deal you can get is to be with a fund that has taken lower risk and still managed to give above average returns. There are few funds that have done that but at least you have a parameter that helps you make that decision.

Essentially, what we are trying to say is that no two funds are alike. They have varying risk-return profiles. As an investor you need to be aware of that and do your own homework before investing in funds. That way you know what you are getting into at the outset and there won't be any surprises later.

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