Funds with the best risk adjusted returns

13 Feb 2023 , 06:09 AM

For instance, you cannot compare the returns of an equity fund with that of a debt fund or a commodity fund. Even within equities, it is hard to compare the returns of a large cap fund with a small cap fund or even a growth fund with a value fund. However, amidst this apples versus oranges debate, the one way to compare these diverse categories of funds is on the basis of risk-adjusted returns.

Using risk adjusted returns for mutual funds?

There are several different ways to use risk adjusted returns. One way is to use the Treynor ratio that uses Beta as a measure or risk. The other is to use the Sharpe approach, using standard deviation as a measure of risk. The third approach is to use the Fama based decomposition of returns to separate the fund manager driven returns. The problem with these approaches is their complexity and the dependence on assumptions.

To overcome these problems, we look at risk-adjusted returns from a different perspective. Firstly, instead of individual funds we look at fund categories. This overcomes variances in individual performance. Secondly, we use total risk since the assumption that unsystematic risk is diversified is rather fanciful. However, instead of the standard deviation we use the category range as a measure of risk. 

How equity funds rank on risk adjusted returns?

Here we look at equity oriented funds across various categories based on 1 year returns; ranked on range-adjusted returns.

Morningstar Category	Category Average	Top Performer	Bottom Performer	Category Range	Range Adjusted Returns
Sector-Financial Services	7.78	9.84	1.48	8.36	0.9306
Contra	6.14	11.90	1.36	10.54	0.5825
Dividend Yield	3.65	8.31	-1.91	10.22	0.3571
Equity-Infrastructure	5.10	19.37	-1.97	21.34	0.2390
Value	3.21	9.51	-6.28	15.79	0.2033
Small-Cap	2.33	12.30	-5.68	17.98	0.1296
Mid-Cap	2.34	13.44	-7.14	20.58	0.1137
Multi-Cap	2.04	12.41	-6.45	18.86	0.1082
Large & Mid-Cap	0.82	21.46	-12.99	34.45	0.0238
Large-Cap	0.51	8.68	-12.96	21.64	0.0236
ELSS (Tax Savings)	0.20	10.40	-11.68	22.08	0.0091
Focused Fund	-1.14	15.34	-14.31	29.65	-0.0384
Flexi Cap	-1.33	11.96	-11.67	23.63	-0.0563
Equity-ESG	-1.71	9.43	-10.21	19.64	-0.0871
Sector-Healthcare	-6.31	0.03	-22.50	22.53	-0.2801
Sector-Technology	-9.86	-0.88	-18.44	17.56	-0.5615

Data Source: Morningstar

Here are some of the major takeaways. We have excluded FMCG outperformance since the category has only one fund and hence is not representative. The fund category that has done well on risk-adjusted returns is the financial services fund while the bottom performer is the Technology funds. That is hardly surprising. 

Financials saw the best traction in last one year due to the positive loan spreads while IT bore the brunt of domestic salary costs, attrition, global weakness etc. Interestingly, contra and dividend yield were among the other top performing categories. The bottom performing categories over the last one year included healthcare and ESG funds too.

How debt funds rank on risk adjusted returns?

Here we look at debt oriented funds across various categories based on 1 year returns and have then ranked them on range adjusted returns.

Morningstar  Category	Category  Average	Top  Performer	Bottom  Performer	Category  Range	Range Adjusted  Returns
10yr Government Bond	2.41	3.05	0.82	2.23	1.0807
Long Duration	3.27	4.71	1.35	3.36	0.9732
Money Market	4.59	6.26	0.12	6.14	0.7476
Low Duration	4.34	6.04	-0.01	6.05	0.7174
Ultra-Short Duration	4.60	6.50	0.03	6.47	0.7110
Government Bond	2.91	5.48	-1.49	6.97	0.4175
Dynamic Bond	3.75	11.76	–	11.76	0.3189
Corporate Bond	3.07	5.34	-5.01	10.35	0.2966
Floating Rate	4.41	16.78	0.75	16.03	0.2751
Banking & PSU	3.30	10.73	-1.64	12.37	0.2668
Medium to Long Duration	3.31	11.30	-1.92	13.22	0.2504
Short Duration	4.41	27.76	-1.07	28.83	0.1530
Medium Duration	3.93	25.94	-1.87	27.81	0.1413

Data Source: Morningstar

Here are some major takeaways. We ignored the Credit risk fund underperformance since the category returns are skewed by low base returns on one fund. The fund category that has done well on risk-adjusted returns basis is the long duration funds and the 10-year government security funds. Normally, long duration funds tend to underperform in a rising interest scenario, but these are the ones to outperform in the last one year. 

That is less about returns and more about the low risk entailed in these funds. Among the worst performers on a risk adjusted category were short duration and medium duration funds. Clearly, here again, the issue is not about returns, but about risk. The moral of the story is that in difficult market conditions and challenging macro environment, the outperformers have not been the return chasers but the risk managers.

How Miscellaneous funds rank on risk adjusted returns?

Having seen the risk-adjusted performance of pure equity and pure debt funds, we categorized all other funds into a residual category. This includes the hybrid funds, the passive funds and the commodity funds. 

Morningstar Category	Category Average	Top Performer	Bottom Performer	Category Range	Range Adjusted Returns
Sector – Precious Metals	13.75	17.43	4.50	12.93	1.0634
Arbitrage Fund	4.48	6.14	1.35	4.79	0.9353
Dynamic Asset Allocation	3.99	14.40	-3.59	17.99	0.2218
Equity Savings	2.48	6.86	-5.31	12.17	0.2038
Conservative Allocation	3.82	21.80	-3.96	25.76	0.1483
Liquid	4.69	46.80	–	46.80	0.1002
Aggressive Allocation	1.29	7.74	-6.09	13.83	0.0933
Balanced Allocation	-1.25	-0.66	-1.89	1.23	-1.0163

Data Source: Morningstar

On risk adjusted terms, the top performer among miscellaneous funds are gold funds. Thanks to the geopolitical risk, gold has been a sought after asset in the last one year and that is evident from the risk-adjusted returns. Arbitrage funds have also been among the top performers, but that is more because the discretionary allocation funds have not done well.

In a sense, the volatile markets have been hardly conducive for any form of discretionary asset allocation. The highly popular Balance Advantage Funds (BAFs) have been among the worst performers in terms of risk-adjusted returns and that explains why investor interest in this category has been waning of late. For the last one year, passive gold ruled the roost.

Did change basis 5 years risk adjusted returns?

All the above risk-adjusted returns analysis have been done on 1-year returns and one can argue that they are vulnerable to short-term moves. Hence we undertook a similar analysis of 5-year risk-adjusted returns. Here are some of the key findings.

1. We start with equity funds risk-adjusted returns over 5 years on CAGR basis. Again we exclude FMCG as an outlier, so the top performing equity funds over 5 years on risk adjusted returns are ESG funds, technology funds and healthcare funds. Infrastructure, ELSS funds and small cap funds were among the bottom performers over 5 years.

    

2. How about debt funds over 5-year risk-adjusted returns? Even on a risk adjusted basis, 10-year government bond funds and long duration funds figured in the top-3 categories. The surprise inclusion is floating rate funds. At the bottom of the heap are credit risk funds, dynamic funds and medium duration funds; classic discretionary risks.

    

3. How did the other categories perform over 5 years. Once again, gold funds are on the top, with allocation funds doing a lot better over a 5 year period. Liquid funds are at the bottom, not due to low returns but due to high risk.

Risks adjusted analysis of fund categories always have an interesting story to tell. If not anything else, it underlines the importance of focusing more on asset allocation and less on fund selection.