{"id":9563,"date":"2022-07-26T18:58:30","date_gmt":"2022-07-26T13:28:30","guid":{"rendered":"https:\/\/www.tickertape.in\/blog\/?p=9563"},"modified":"2022-08-26T16:38:23","modified_gmt":"2022-08-26T11:08:23","slug":"how-to-assess-risk-in-mutual-funds-and-pick-the-right-one","status":"publish","type":"post","link":"https:\/\/www.tickertape.in\/blog\/how-to-assess-risk-in-mutual-funds-and-pick-the-right-one\/","title":{"rendered":"How To Assess Risk in Mutual Funds and Pick the Right One?"},"content":{"rendered":"\n<p><em>Harsh Vora is a proprietary investor and day trader with more than 10 yrs of experience in financial markets and is interviewed on ET NOW.<\/em><\/p>\n\n\n\n<p>The <a href=\"https:\/\/www.tickertape.in\/blog\/bull-market\/\">bull market<\/a> that began in 2020 may have led many of us, especially those who entered the stock markets in the past 2 yrs, to believe that stock markets are a source of easy money \u2013 especially with India\u2019s growth story remaining intact.<\/p>\n\n\n\n<p>But, the downturn in <a href=\"https:\/\/www.tickertape.in\/blog\/what-is-equity\/\">equity<\/a> markets since October 2021 and the resulting drawdown in investor portfolios have once again brought risk at the forefront of investment strategies. Most of us view risk as the probability of a loss of capital. What if my largest stock position falls by 40%? In finance, however, this would be an incomplete understanding of risk.&nbsp;<\/p>\n\n\n\n<div id=\"ez-toc-container\" class=\"ez-toc-v2_0_66_1 counter-hierarchy ez-toc-counter ez-toc-custom ez-toc-container-direction\">\n<div class=\"ez-toc-title-container\">\n<p class=\"ez-toc-title \" >Table of Contents<\/p>\n<span class=\"ez-toc-title-toggle\"><\/span><\/div>\n<nav><ul class='ez-toc-list ez-toc-list-level-1 ' ><li class='ez-toc-page-1 ez-toc-heading-level-2'><a class=\"ez-toc-link ez-toc-heading-1\" href=\"https:\/\/www.tickertape.in\/blog\/how-to-assess-risk-in-mutual-funds-and-pick-the-right-one\/#Standard-deviation\" title=\"Standard deviation\">Standard deviation<\/a><ul class='ez-toc-list-level-3' ><li class='ez-toc-heading-level-3'><a class=\"ez-toc-link ez-toc-heading-2\" href=\"https:\/\/www.tickertape.in\/blog\/how-to-assess-risk-in-mutual-funds-and-pick-the-right-one\/#How-to-read-this-figure\" title=\"How to read this figure?&nbsp;\">How to read this figure?&nbsp;<\/a><\/li><li class='ez-toc-page-1 ez-toc-heading-level-3'><a class=\"ez-toc-link ez-toc-heading-3\" href=\"https:\/\/www.tickertape.in\/blog\/how-to-assess-risk-in-mutual-funds-and-pick-the-right-one\/#Which-funds-normally-have-the-lowest-volatility-standard-deviation\" title=\"Which funds normally have the lowest volatility (standard deviation)?\">Which funds normally have the lowest volatility (standard deviation)?<\/a><\/li><\/ul><\/li><li class='ez-toc-page-1 ez-toc-heading-level-2'><a class=\"ez-toc-link ez-toc-heading-4\" href=\"https:\/\/www.tickertape.in\/blog\/how-to-assess-risk-in-mutual-funds-and-pick-the-right-one\/#Sharpe-ratio\" title=\"Sharpe ratio\">Sharpe ratio<\/a><\/li><\/ul><\/nav><\/div>\n<h2 class=\"wp-block-heading\"><span class=\"ez-toc-section\" id=\"Standard-deviation\"><\/span><strong>Standard deviation<\/strong><span class=\"ez-toc-section-end\"><\/span><\/h2>\n\n\n\n<p>Consider this: a stock has generated an average return of 18% per year over the last 10 yrs. If you <a href=\"https:\/\/www.tickertape.in\/blog\/why-should-you-prioritise-investing\/\">invest<\/a> in this stock expecting a similar return going forward, then the risk that matters is not just the potential drawdown in stock price from your purchase price. Since this is a long-term investment, the risk is how much your actual return deviates from your expected return every year.<\/p>\n\n\n\n<p>In other words, risk should be measured as a dispersion of actual returns around your expected return. In fancy finance jargon, this dispersion is called standard deviation. The higher the standard deviation of an asset \u2013 whether individual stocks or <a href=\"https:\/\/www.tickertape.in\/blog\/mutual-funds\/\">mutual funds<\/a> \u2013 the greater the risk.<\/p>\n\n\n\n<p>This is why small-cap and <a href=\"https:\/\/www.tickertape.in\/blog\/mid-cap-stock\/\">mid-cap stocks<\/a> are considered riskier than large-cap ones. Their actual returns are more widely dispersed around expected returns. In other words, <a href=\"https:\/\/www.tickertape.in\/blog\/volatility\/\">volatility<\/a> in their returns is higher than large-cap.&nbsp;<\/p>\n\n\n\n<p>Let\u2019s look at the <a href=\"https:\/\/www.tickertape.in\/blog\/netra-december-2023-market-analysis-report-5-key-takeaways\/\">DSP Mutual Fund<\/a> schemes to get an idea of how to look at standard deviation. As you may notice below, the standard deviation of the <a href=\"https:\/\/www.tickertape.in\/mutualfunds\/dsp-small-cap-fund-M_DSPSM?utm_source=blog&amp;utm_medium=gart&amp;utm_campaign=harshvora\" target=\"_blank\" rel=\"noreferrer noopener\">DSP Small-Cap<\/a> fund is the highest (18.81%), while that of its flexi cap fund (which is essentially a proxy for large-cap) is the lowest (17.24%). This should be the case as per our discussion on risk above.&nbsp;<\/p>\n\n\n\n<div class=\"wp-block-image\"><figure class=\"aligncenter\"><img decoding=\"async\" src=\"https:\/\/lh4.googleusercontent.com\/vRZiO1stXgGSOQsrvPqhKmWv4RSK8yBjPaRySzb46pQD1ijIW90nI2jvz38m4FYZ6ZRbmqvTx0vdwDX_YGkJMREyMbB5syGVPKJkDZkmBFiJ68AHWRo3t-IpTM1xJDXz8hn5odTW\" alt=\"\"\/><\/figure><\/div>\n\n\n\n<h3 class=\"wp-block-heading\"><span class=\"ez-toc-section\" id=\"How-to-read-this-figure\"><\/span><strong>How to read this figure?<\/strong>&nbsp;<span class=\"ez-toc-section-end\"><\/span><\/h3>\n\n\n\n<p>Assuming that the DSP Small Cap has an average return of 21.88% over the last 10 yr, about 68% of the time, the fund\u2019s returns would fall between 3.07% (which is 21.88 &#8211; 18.81) and 40.69% (which is 21.88 + 18.81).<\/p>\n\n\n\n<p>But, why 68% of the time? This is because we are assuming a normal distribution \u2013 that is, we are assuming that most of the time, the fund would generate average or near average returns and the rest of the time, its returns would taper off symmetrically toward the extreme. This is only a matter of statistical convenience and works for most practical purposes.&nbsp;<\/p>\n\n\n\n<h3 class=\"wp-block-heading\"><span class=\"ez-toc-section\" id=\"Which-funds-normally-have-the-lowest-volatility-standard-deviation\"><\/span><strong>Which funds normally have the lowest volatility (standard deviation)?<\/strong><span class=\"ez-toc-section-end\"><\/span><\/h3>\n\n\n\n<p><a href=\"https:\/\/www.tickertape.in\/blog\/overnight-mutual-funds\/\">Overnight funds<\/a>, which invest most of their assets in the government\u2019s treasury bills (short-term instruments spanning 90 to 182 days), money market funds, or ultra-short duration funds \u2013 all of these have low risk. But remember, they also come with low returns. Most overnight funds have had a 3-yr compounded growth rate of less than 4% as they invest in safe assets. On the other hand, most thematic or sectoral funds and small-cap funds have a higher standard deviation.<\/p>\n\n\n\n<p>Next, let\u2019s look at another important metric that gives us an idea of a mutual fund\u2019s return performance but in relation to the risk taken by the fund manager. This is called the <a href=\"https:\/\/www.tickertape.in\/blog\/sharpe-ratio\/\">Sharpe Ratio<\/a>.<\/p>\n\n\n\n<h2 class=\"wp-block-heading\"><span class=\"ez-toc-section\" id=\"Sharpe-ratio\"><\/span><strong>Sharpe ratio<\/strong><span class=\"ez-toc-section-end\"><\/span><\/h2>\n\n\n\n<p>What is the historical return that a mutual fund has given for every 1 unit of risk taken in the fund? Furthermore, is the return generated by the fund an outcome of taking excessive risk or is it owing to the fund manager\u2019s skill? Remember, a higher risk is usually accompanied by a higher return, but is your risk appetite compatible with that higher risk? The <a href=\"https:\/\/www.tickertape.in\/blog\/sharpe-ratio\/\">Sharpe ratio<\/a> attempts to answer these questions. The higher the Sharpe ratio, the better for the investor.<\/p>\n\n\n\n<p>The formula is simply the return given by the fund minus the return given by a risk-free asset divided by the standard deviation of returns. We subtract the risk-free rate because we wish to know what \u201cexcess return\u201d (that is, in excess of the risk-free rate) the fund house has generated per unit of risk.<\/p>\n\n\n\n<p>For instance, if the return generated by the fund is 21.88%, the risk-free rate (which is the 10 yr government bond rate) is 7%, and the fund\u2019s standard deviation is assumed to be 18.86%, then the fund\u2019s Sharpe ratio would be (21.88-7)\/18.86 or 0.79. In other words, the fund has generated an excess return of 0.79% per unit of risk.<\/p>\n\n\n\n<p>Let\u2019s look at HDFC fund\u2019s small, mid, and large-cap schemes and compare their Sharpe ratio. As seen below, the <a href=\"https:\/\/www.tickertape.in\/mutualfunds\/hdfc-small-cap-fund-M_HDFSU?utm_source=blog&amp;utm_medium=gart&amp;utm_campaign=harshvora\" target=\"_blank\" rel=\"noreferrer noopener\">HDFC Small-Cap Fund <\/a>has delivered a very poor Sharpe ratio of 0.04. This means it has generated only 0.04% excess return for every 1 unit of risk.&nbsp;<\/p>\n\n\n\n<div class=\"wp-block-image\"><figure class=\"aligncenter\"><img decoding=\"async\" src=\"https:\/\/lh3.googleusercontent.com\/5uC9AspHR-BhhLVCRtW6nPCufTZiSSevPcCnM9p48Vt-dOV_LJa6c40VeZAbhsJM4MtxNpW7wj601xPzHoOFj1kpXHZloPxJ3RtSdjI90DNTAz7TdlG5ku1buUNLyILB3aB9R0yN\" alt=\"\"\/><\/figure><\/div>\n\n\n\n<p>Remember, however, that having a high Sharpe ratio is not always desirable. To judge the quality of the Sharpe ratio, one must pay attention to the inputs of this ratio. For instance, a fund generating 5% excess return with 3% risk would have a Sharpe ratio of 1.67 (which is 5 divided by 3). While this is greater than a fund which generates a 10% excess return with an 8% risk (having a Sharpe ratio of 1.25), the former\u2019s excess return itself is lower.&nbsp;<\/p>\n\n\n\n<div class=\"wp-block-image\"><figure class=\"aligncenter\"><img decoding=\"async\" src=\"https:\/\/lh4.googleusercontent.com\/qoNaMMt8bPBduEYg-OfuM6bilxR1_iIfj0-A0Yl-RMuXN2ApLpErOSbDXSqT3Ac8lxZMfdu9il9qYn6s77CLcRmyJKw9dpJcNmBq7_UZ-ITIFAImeJsFsGBMixPUCl1R0T47iUTD\" alt=\"\"\/><\/figure><\/div>\n\n\n\n<p>So while the Sharpe ratio is an important metric to judge the \u201crisk-adjusted\u201d return of the fund, one must be mindful of its use.<\/p>\n\n\n\n<p>While there are other metrics that may provide information about a fund\u2019s riskiness, these two \u2013 standard deviation and Sharpe ratio \u2013 are quite holistic. The former informs us about the riskiness of the fund, whereas the latter tells us about the return per unit of risk. <a href=\"https:\/\/www.tickertape.in\/screener\/mutual-fund?utm_source=blog&amp;utm_medium=gart&amp;utm_campaign=harshvora\" target=\"_blank\" rel=\"noreferrer noopener\">Tickertape\u2019s Mutual Fund Screener<\/a> is an easy way to find mutual funds with the lowest standard deviation and the highest Sharpe ratio.<\/p>\n","protected":false},"excerpt":{"rendered":"<p>Risk is often viewed as the probability of a loss of capital. But is that all? Harsh Vora discusses more on the subject and two metrics to assess a mutual fund\u2019s risk.<\/p>\n","protected":false},"author":60,"featured_media":9574,"comment_status":"open","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"inline_featured_image":false,"_lmt_disableupdate":"no","_lmt_disable":"no","footnotes":""},"categories":[8,1743],"tags":[306,1213,132],"acf":[],"modified_by":"Aradhana Gotur","jetpack_featured_media_url":"https:\/\/www.tickertape.in\/blog\/wp-content\/uploads\/2022\/07\/TT-26-July-Risk-in-Mutual-Funds-BB-01-scaled.jpeg?wsr","_links":{"self":[{"href":"https:\/\/www.tickertape.in\/blog\/wp-json\/wp\/v2\/posts\/9563"}],"collection":[{"href":"https:\/\/www.tickertape.in\/blog\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/www.tickertape.in\/blog\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/www.tickertape.in\/blog\/wp-json\/wp\/v2\/users\/60"}],"replies":[{"embeddable":true,"href":"https:\/\/www.tickertape.in\/blog\/wp-json\/wp\/v2\/comments?post=9563"}],"version-history":[{"count":3,"href":"https:\/\/www.tickertape.in\/blog\/wp-json\/wp\/v2\/posts\/9563\/revisions"}],"predecessor-version":[{"id":10006,"href":"https:\/\/www.tickertape.in\/blog\/wp-json\/wp\/v2\/posts\/9563\/revisions\/10006"}],"wp:featuredmedia":[{"embeddable":true,"href":"https:\/\/www.tickertape.in\/blog\/wp-json\/wp\/v2\/media\/9574"}],"wp:attachment":[{"href":"https:\/\/www.tickertape.in\/blog\/wp-json\/wp\/v2\/media?parent=9563"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/www.tickertape.in\/blog\/wp-json\/wp\/v2\/categories?post=9563"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/www.tickertape.in\/blog\/wp-json\/wp\/v2\/tags?post=9563"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}