Bets mutual fund categories on risk adjusted returns

29 May 2024 , 10:53 PM

WHY TWO FUNDS WITH SAME RETURNS ARE NOT SIMILAR

We often rank mutual funds on returns. That is quite simple. If the NAV of the fund appreciates from ₹100 to ₹118 in a year, it would translate into returns of 18% per annum. For longer time periods; like 3 years, 5 years or longer, the CAGR returns will be used instead of point-to-point returns. For example, if ₹100 grows to ₹142.38 at the end of 3 years, then the compounded annual growth rate (CAGR) returns will be 12.5% per annum. However, there is a major shortcoming in looking at mutual funds purely from a returns perspective (even if you use CAGR). Let us understand why.

Let us look at two funds and their NAV over a 3 year period in the table below.

Fund Name	Year 1-Start	Year 1-End	Year 2-End	Year 3-End
Fund Alpha	100.00	115.00	92.00	150.10
Yearly Returns	N.A.	15.00%	-20.00%	63.15%
Fund Beta	100.00	114.00	133.00	150.10
Yearly Returns	N.A.	14.00%	16.67%	12.86%

What is the similarity between Fund Alpha and Fund Beta above. The similarity is that both the funds have grown ₹100 NAV into ₹150.10 NAV over 3 years. That translates into 14.5% CAGR returns in both the cases, which is quite attractive for an equity fund. However, the difference lies in the consistency returns. For instance, Fund Alpha gave modest returns in 1 year, negative returns in the second year and supernormal returns in the third year.

In contrast, the Fund Beta has given stable returns around the mean in each of these years. In other words, Fund Alpha is much more volatile than Fund Beta. In financial parlance, risk is almost synonymous with volatility and since the volatility of Fund Alpha is higher. But why exactly does stability of returns matter for an investor. Let us look at that point in greater detail pertaining to the downside of higher volatility and how to measure the same. We now turn to the idea and methodology of risk adjusted returns.

WHY RISK ADJUSTED RETURNS MATTER MORE THAN PURE RETURNS

The consistency returns is important because it makes you neutral to the timing of entry and exit in the fund. For instance, had you invested in Fund Alpha at the start, you would have been disappointed at the end of year 2 and would have booked the loss and exited. However, had you entered the fund at the end of year 2, the returns would have been a flattering 63.15% in the first year itself. That is the problem with volatile funds like Fund Alpha. The returns that you earn are too dependent on the timing of entry and exit. However, when you look at a more stable and matured fund like Fund Beta, these funds are consistent over time and hence timing becomes immaterial. That brings us to the key question of; how to calculate and measure risk-adjusted returns in mutual funds.

In the regular mutual funds analysis, there are some well accepted measures of risk adjusted returns like the Sharpe Ratio and the Treynor Ratio. Now, most of the major mutual funds even disclose these ratios as part of the monthly fund fact sheet put out by them. This gives an idea of whether the returns generated by the fund are actually justified by the quantum of risk taken by the fund manager, or whether the fund manager is shooting from the hip with your hard earned money. However, the Sharpe and Treynor are much more suited to individual funds, while we are looking at categories of funds. Hence to take a simple proxy, we will use range as a measure of volatility or risk and then adjust the average returns of the category accordingly. Here is the rankings for the active debt category.

RISK ADJUSTED RETURNS OF DEBT / INCOME FUNDS

We start with the risk adjusted returns of debt funds in India. Again, we are not getting into specific funds, but focusing just on fund categories. Here the range is the difference between the top performer and the bottom performer for each category and this range has been used as the risk measure to get risk adjusted returns. The data pertains to 5-year returns in all cases, so this is long-term CAGR returns. The risk-adjusted returns here, does not mean anything in isolation. It is just a metrics for comparing funds in the category. A fund can rank high on risk adjusted returns; either by giving high returns or by managing risk a lot more smartly.

Morningstar Category	Category Average	Top Performer	Bottom Performer	Return Range	Risk Adj Returns
Long Duration	5.66	7.73	3.39	4.34	1.3041
Money Market	5.20	6.40	2.02	4.38	1.1872
Floating Rate	6.17	9.06	3.76	5.30	1.1642
Government Bond	6.20	8.32	2.18	6.14	1.0098
Medium to Long Duration	5.48	7.92	2.34	5.58	0.9821
10 yr Government Bond	5.70	7.55	1.74	5.81	0.9811
Short Duration	5.52	9.46	2.42	7.04	0.7841
Banking & PSU	5.88	7.73	-0.03	7.76	0.7577
Low Duration	4.99	6.83	0.05	6.78	0.7360
Corporate Bond	5.77	12.44	1.26	11.18	0.5161
Medium Duration	5.00	9.47	-0.39	9.86	0.5071
Credit Risk	4.84	8.22	-1.61	9.83	0.4924
Ultra Short Duration	4.95	11.37	0.24	11.13	0.4447
Dynamic Bond	5.78	14.23	0.00	14.23	0.4062

Data Source: Morningstar India

Here are some of the key takeaways from the analysis of risk-adjusted returns of debt funds in India over the last 5 years.

• At the top are the longer duration funds and government funds. Money market funds may be offering lower returns, but the risk is also lower. However, it must be said that due to the compression of the spread between long tenure and short tenure debt, the shorter debt is also looking good. Floating rate funds gained from rising rates.
• What about the laggards in terms of risk adjusted returns. The dynamic bond funds with duration discretion to fund managers has scored low. Even other categories like ultra short duration, medium duration and credit risk funds have also lagged in terms of 5-year CAGR returns. It is a case against discretion and assumption of credit risk.

Longer tenure debt funds and floating rate funds have done well, but funds at the shorter end, which did not venture into liquidity risk have also done well. This is at a time, when flows into debt funds have been fairly erratic. The flows appear to have gravitated broadly in line with the 5-year risk adjusted returns.

RISK ADJUSTED RETURNS OF EQUITY FUNDS

We now turn to the risk adjusted returns delivered by equity funds. The methodology is the same. The range (measure of dispersion) has been used as the adjusting factor to calculate risk-adjusted returns. One point to note here is that some of the outliers like Energy Funds, ESG Funds and FMCG funds were removed from the list as limited universe was distorting the monthly averages and overstating risk adjusted returns.

Morningstar Category	Category Average	Top Performer	Bottom Performer	Return Range	Risk Adj Returns
Sector – Technology	24.00	25.79	19.11	6.68	3.5928
Sector – Healthcare	24.11	28.78	19.71	9.07	2.6582
Contra	19.90	27.21	18.22	8.99	2.2136
Dividend Yield	19.92	24.26	14.63	9.63	2.0685
Value	18.78	24.65	12.56	12.09	1.5533
Large-Cap	15.75	19.12	8.92	10.20	1.5441
Multi-Cap	20.97	30.64	16.45	14.19	1.4778
Large & Mid- Cap	19.00	28.02	12.65	15.37	1.2362
Mid-Cap	23.45	35.18	15.14	20.04	1.1702
Focused Fund	16.33	23.90	9.61	14.29	1.1428
Equity- Infrastructure	24.44	36.60	14.54	22.06	1.1079
Small-Cap	26.49	41.17	16.93	24.24	1.0928
ELSS (Tax Savings)	17.71	33.75	10.99	22.76	0.7781
Sector – Financial Services	11.94	17.75	2.02	15.73	0.7591
Flexi Cap	17.11	32.28	8.80	23.48	0.7287

Data Source: Morningstar India

Here are some of the key takeaways from the analysis of risk-adjusted returns of active equity funds in India over the last 5 years. Note that these are CAGR returns over 5 years.

• If you thought that technology and healthcare were boring sectors, think again. Over the last 5 years, these two sectoral fund have delivered the best risk adjusted returns among equity funds. Surprisingly, contra funds and value funds that look for deep value in undervalued stocks have also done well and figure at the top on risk adjusted returns.
• What about the laggards in terms of risk adjusted returns. The much touted flexi-cap funds figure at the bottom of the fund heap. Firstly, the average 5-year CAGR returns o flexi-cap funds are about 386 bps lower than multi-cap funds. Clearly, formula investing is working better than discretion in this case. Other laggards include financial services funds, which is not surprising. However, the high risk of small caps has pushed it to the bottom on risk adjusted returns. ELSS also lags, possibly due to low demand under NTR.

Over the longer term, it is the more stable stories that have done well; not because they gave better returns but because they managed risk better. The laggards has some sharp messages. Rule based allocation has done better than discretion while managing risk will be critical going ahead.

RISK ADJUSTED RETURNS OF HYBRID / ALLOCATION FUNDS

We now turn to the hybrid or allocation funds. These funds were one of the stars of FY24 in term of public interest and flows. Here is the story of how the hybrid and allocation funds ranked on the basis of risk adjusted returns.

Morningstar Category	Category Average	Top Performer	Bottom Performer	Return Range	Risk Adj Returns
Balanced Allocation	10.32	13.06	7.67	5.39	1.9147
Dynamic Asset Allocation	12.00	19.11	7.58	11.53	1.0408
Equity Savings	8.91	13.61	3.10	10.51	0.8478
Aggressive Allocation	14.94	25.47	6.17	19.30	0.7741
Conservative Allocation	7.85	12.81	1.70	11.11	0.7066

Data Source: Morningstar India

Here are some of the key takeaways from the analysis of risk-adjusted returns of hybrid / allocation funds in India over the last 5 years. Note that these are CAGR returns over 5 years.

• There is no clear trending emerging in allocation fund on formula based allocation versus rule-based allocation. While all these are allocation funds, they are vastly different in intent and the portfolio mix. One thing is that greater proportion of equity has helped the allocation funds as that has been the story of the last few years, especially since the pandemic. However, in most allocation funds, how the allocations were tweaked mattered a lot more.
• There are two funds of specific note here. The dynamic allocation funds or balanced advantage funds (BAFs) are largely a discretionary play on a combination of equity and debt. Most of the BAFs have outperformed in this period by keeping a larger allocation to equity. That is the reason, the discretion based funds have done better as asset allocators than the rule based funds, which tend to become too rigid in largely dynamic risk and return environment.

Over the longer term, it has been the theme of discretion that has worked better than rule based management of the equity debt mix.

RISK ADJUSTED RETURNS OF ALTERNATE FUNDS

We finally look quickly at the category of alternate funds, but have only considered 3 categories of funds here viz., gold / silver funds, arbitrage funds and liquid funds. Here is a quick dekko.

Morningstar Category	Category Average	Top Performer	Bottom Performer	Return Range	Risk Adj Returns
Sector – Precious Metals	16.76	17.12	16.13	0.99	16.9293
Arbitrage Fund	4.95	6.14	1.75	4.39	1.1276
Liquid	4.24	5.94	-2.73	8.67	0.4890

Data Source: Morningstar India

Here are some of the key takeaways from the analysis of risk-adjusted returns of alternate funds in India over the last 5 years. Note that these are CAGR returns over 5 years.

• Precious metal funds; gold and silver funds have not only emerged as the best performing fund on risk-adjusted returns in the alternate category, but it ranks on top across all categories. Apart from the attractive returns on gold, the low volatility and selection risk has made it an interesting proposition.
• The other two are actually competitors with the competition intensifying in the last year or so. The elevated levels of the market resulted in higher yields on arbitrage funds leading to an exodus of funds from liquid funds to arbitrage funds. Compared to liquid funds, arbitrage fund delivered higher returns with lower risk.

What are the key takeaways from the ranking on risk adjusted returns. Including risk gives a different perspective to performance. It actually gives a more realistic picture of performance.