Which funds gave the best risk adjusted returns?

Let us first understand why risk is so important?

Mar 12, 2021 09:03 IST India Infoline News Service

The most common metrics we use to measure a mutual funds is returns. If it is a longer timeframe of 3-5 years, we normally consider compounded annual returns, which is a more realistic picture. However, all these measures of returns have a major shortcoming in that they do not consider risk. Let us first understand why risk is so important?

Assume there are 2 funds. Fund Alpha has given 13% returns over last 1 year while Fund Beta has given 14.5% returns. Clearly, Fund Beta looks like a better choice. Now let us add one level of complication. Alpha has earned the returns with 10% volatility and Beta has earned these returns with 35% volatility. So, Fund Beta has earned higher returns by taking on too much risk. That is what the concept of risk-adjusted return highlights.

Using risk adjusted returns for fund categories over last 5 years

Mutual fund returns give a distorted picture in the short run. However, if you take a longer-term view of around 5 years, then cycles are evened out. That is when the real winners will come about. How do we use the idea of risk-adjusted returns in this situation?

We can use range, which is the gap between the highest return and the lowest returns in each category. Bigger the range, higher the volatility and greater the risk of that category. If we divide the average returns of the category of funds by its range of returns, we will get a good approximation of risk-adjusted returns.

Risk adjusted returns for Equity Fund categories

Category Average (%) Leader (%) Laggard (%) Risk Adjusted Returns
Sector – FMCG 12.97 13.73 12.21 8.533
Sector - Technology 22.06 24.55 11.90 1.744
Contra 15.84 20.52 10.13 1.525
Dividend Yield 14.02 18.76 9.22 1.470
Value 14.57 19.43 9.48 1.464
Mid-Cap 16.35 21.56 10.01 1.416
Large-Cap 13.71 19.50 9.34 1.349
Sector - Financial Services 16.32 23.76 11.64 1.347
Multi-Cap 15.40 20.60 8.88 1.314
Small-Cap 16.38 23.34 10.87 1.314
Sector - Healthcare 9.99 14.69 7.05 1.308
Large & Mid- Cap 15.88 23.78 10.61 1.206
Equity- Infrastructure 13.32 17.88 4.62 1.005
ELSS (Tax Savings) 15.52 25.37 8.87 0.941

Data Source: Morningstar

If you consider last 5 years of data, even today, FMCG funds are the star performers on risk-adjusted returns, followed by technology funds and contra funds. Over the last 5 years, value as a theme appears to have played out better than growth.

What stands out about the FMCG funds category is that CAGR return of 12.97% has come with low risk, making fund selection easy and predictable. Themes may come and go but the India consumption story remains a high return / low risk theme for investors. Mid-caps and small-caps did well on returns over 5 years, but that came at the cost of high volatility risk.

Why did ELSS funds, with limited churning, perform so badly? The problem is with the range indicating that a handful of funds are trying to take on too much risk to earn higher returns.

Risk adjusted returns for Debt Fund categories

Category Average (%) Leader (%) Laggard (%) Risk Adjusted Returns
Long Duration 7.37 9.81 6.70 2.370
Floating Rate 6.39 8.65 4.55 1.559
10 yr. Government Bond 7.76 10.23 4.69 1.401
Money Market 5.48 7.84 2.29 0.987
Banking & PSU 6.71 11.29 3.85 0.902
Medium to Long Duration 6.35 9.76 2.16 0.836
Ultra-Short Duration 5.33 8.55 1.73 0.782
Corporate Bond 6.64 12.26 1.63 0.625
Government Bond 7.52 10.87 -2.24 0.574
Dynamic Bond 6.53 10.57 -1.54 0.539
Short Duration 5.76 9.21 -1.93 0.517
Medium Duration 5.45 10.49 -3.30 0.395
Low Duration 4.82 9.23 -3.72 0.372
Credit Risk 3.04 9.37 -18.19 0.110

Data Source: Morningstar

Who are the leaders in the debt fund category over last 5 years? Long duration funds and 10-Year government bond funds are among the leaders. That is not much of a surprise because the rate cuts began in 2015 and the last five year have been a period of falling yields. That is conducive to funds with longer maturity and duration. Floating rate funds leading is a surprise but that is due to the low risk in floating rate funds as funds flock to the handful of variable instruments available. Also, floating rate funds are marginally impacted by interest rate risk.

Credit risk funds at the bottom is understandable considering the fluctuations in returns in the last couple of years. However, the lower duration funds ending up at the bottom is more because short duration funds are impacted more by liquidity shifts. The liquidity has been very volatile since demonetization and that has taken its toll on these short duration funds.

The moral of the story is to focus on risk-adjusted returns on a very elementary basis to shortlist themes to invest within the equity and debt fund category. Fads and trends may look exciting, but stories that deliver boringly consistent and safe returns over a longer period are your best bets.

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