Why You Should Not Look At The Risk-O-Meter When Investing In Mutual Funds?
May 02, 2019

Author: Aditi Murkute

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(Image source: freepik.com)

Investments and risk go hand in hand. There is no such thing as a completely risk-free investment. The only difference is the level of risk each investment avenue carries. And in mutual funds the risk is reduced through diversification and professional management.

But depending on the type of fund, each one has a different level of risk that is suitable for the individual investor's risk profile -represented by a Risk-O-Meter on the offer document.

The basic purpose of the introduction of the Risk-O-Meter is to make investors aware about the investment risk they are taking when selecting a particular mutual fund scheme.

Lately, while analysing new fund offers various fund houses launched, what I have observed is the product labelling is broadly done and isn't indicative of the true inherent risk factor.

For e.g., some funds that carry moderate high risk are marked moderate low risk which is misleading.

Imagine the plight of a conservative investor who invests in a debt fund that indicates low risk but, in fact, has invested in a moderately high-risk fund.

So how can you assess the risk of a fund?

By delving deeper into the details (investment mandate, performance data, etc.) will actually help you assess the actual risk a fund would expose your investment to.

Do you recall Chinmay's story?

Chinmay wanted to know about Systematic Investment plans and its benefit because he was indecisive about it.

Two days ago, he came over to seek my views/advice about a fund's risk!

A fund's risk as per the riskometer is broadly classified as per the category of the fund and does not paint the real picture.

For a new fund offer, one should skim through the Scheme information document (SID) for details like:

  • Allocation of the fund:

    The proportion of assets allocated within each scheme sheds light on the actual exposure of each asset class (equity, debt, sector, market cap, etc.). Sometimes, a fund could be well-diversified across the top 10 stocks in case of equity but investments in a single stock could be very high to offset an otherwise diversified portfolio.

    A fund could be well-diversified across stocks but may pay the price for not diversifying well enough across sectors. The asset allocation table tells you how the fund's net assets are diversified across stocks, debt instruments, and current assets/cash.

    Hence it is advisable to look at stock allocation, sectoral allocation, and asset allocation to know about the exposure of the overall fund.

  • Investment strategy:

    Every fund will follow a unique investment strategy to construct the portfolio. It could be either a top-down and/or bottom-up approach, etc. Based on the investment strategy, one can gauge the implications of the market risks, price risk, default risk, interest risks, amongst others that the fund manager encounters while building a portfolio.

    Besides what risk mitigation strategies-hedging, arbitrage, diversification, credit research, etc.- are used will also give you an idea about the severity of the overall risk.

  • Fund manager's track record:

    By checking the returns of existing funds managed by the fund manager over a period of 1 year, 3 years and 5 years with respect to the benchmark, can give you an understanding of the proficiency skills of the fund manager.

    During the turbulent times, how the fund has performed will provide insights and give some level of confidence to the investors of the manager's capabilities.

Further I explained to Chinmay that if he wants to invest in an existing fund, he should evaluate its risk against returns based on the performance of over 1-year, 3-year, and 5-year time frames, along with the investment mandate.

Although there are various measures used to calculate risks these three risk-reward ratios are the most crucial ones.

  • Standard Deviation (SD):

    Standard deviation will let you know the extent of volatility of the fund. It explains the occurrence of variation in the fund's performance. It denotes by how much a fund's return would deviate from the mean or average return. Higher the number, riskier the fund is.

    For example, out of two funds, X and Y, with a standard deviation of 6% and 8% respectively. Fund Y is more volatile.

  • Sharpe ratio:

    Simply put, it helps an investor understand how to determine the fund carrying highest risk with respect to the highest returns one is willing for. Rather a compensation (risk) to gain high rewards.

    A measure to quantify the return you can expect over and above a certain risk-free rate, (for example, the bank deposit interest 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 justifies the risk it has taken. Higher the Sharpe Ratio, higher you are compensated for the risk the fund has taken.

    As seen in the table below, I showed Chinmay an example of two funds A & B. As follows:

    Table: Sharpe ratio of two funds

    Fund

    A

    B

    Assumed Average annual return (%)

    12

    14

    Assumed Standard deviation (%)

    6

    6

    Assumed risk-free rate (%)

    7

    7

    Sharpe Ratio will be…

    0.83

    1.1

    (Illustration purpose only)


    Fund B justifies the risk taken vide higher risk-adjusted returns compared to Fund A. Hence this ratio will serve as a checkpoint to make sure a fund's returns are in-sink with its risk level.

  • Sortino Ratio

    Sortino ratio evaluates the risk-adjusted returns, but considers primarily the downside risk involved. It is calculated as:


    This ratio focuses on negative deviation that is missed out in Sharpe ratio. A higher Sortino ratio indicates better is the risk adjusted returns.

    Suppose Fund A has been generating an 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 and rest all will be ignored. Through this measure of evaluation, the fund is expected to deliver at least a threshold return that investors expect.

In short...

The above points are a lot for an average investor to look in to. It involves a lot of number crunching and much of the data is not easily available in one place. Yet, these factors are of utmost importance to gauge the inherent risk and one should not blindly follow the Risk-o-meter. It will help you to narrow down on the top funds.

Besides, it is equally important to understand that whatever fund you choose is as per your:

Investment goals;

Investment time horizon;

Risk profile;

Financial position;

 Watch this short video on selecting mutual fund schemes:

 

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