Dividend yield funds and gold funds shine over a 10-year period

17 Nov 2023 , 12:41 PM

Using risk adjusted returns over a 10-year period

Returns on mutual funds most of us understand quite easily. For instance, if you are invested in a growth plan of an equity fund and the NAV has appreciated from Rs110 to Rs123 in 1 year, then your annual return on the equity fund is 11.82%. That looks simple and mathematically elegant. The problem arises when you are comparing two funds and deciding which fund to invest in. Let us say, both funds have given around 11.82% returns, then you have a tough choice to make. Can you then be indifferent to the selection of the fund. On the contrary, you need to fine tune this return definition by factoring in risk and looking at risk-adjusted returns, rather than just the returns.

Before we get into risk-adjusted returns as a concept, let us first understand the narrative behind risk adjusted returns. Assume there are 2 large cap equity funds with almost the same AUM size. While Fund-A has generated 14.6% returns in the last one year, Fund-B has generated 18.3% returns in the last year. There is one more data point. Fund-A did this with standard deviation of 12% while Fund-B earned higher returns with standard deviation of 29%. Clearly, Fund-B has been taking on more risk in the quest for higher returns. Instead of returns, if you look at risk adjusted returns, you will realize that Fund-B has not generated higher returns with higher skill, but by merely taking more risk with your money. That is the subtle difference that risk adjusted returns capture.

Why 10 years and how we use risk-adjusted returns?

In the realm of mutual funds, there are varying definitions of the long term. Some start with 5 years and go all the way to 15 years. Typically, in a slightly more complex economy like India a ten year period would be the right way to look at the risk adjusted returns. In the Indian context, if you take a time frame of 10 years, you get to see about 3 cycles in equities and 3 cycles in debt. That is a good experience stack on which to review and compare the performance of various asset classes. Also, it begs the question; how do we can calculate risk adjusted returns.

The best way to calculate risk adjusted returns is to divide the average returns by the standard deviation. However, calculation of standard deviation can be quite complex and it is possible to get similar results by using a simpler version of variance. In this case, we use range instead of standard deviation. Returns on CAGR basis are looked at various sub-categories of funds and then such returns are divided by the range of returns to get the risk-adjusted returns. This 10-year risk-adjusted returns are then used for ranking the various fund categories under the headers of equity funds, income funds and alternative funds.

How equity funds performed over 10 years on risk-adjusted returns

The table below captures the performance of various categories of equity funds based on risk adjusted returns. 

Morningstar  Category	Category Average	Top Performer	Bottom Performer	Range Variance	Risk Adjusted Returns
Dividend Yield	15.41	17.03	14.06	2.97	5.1886
Sector – Healthcare	15.47	18.58	13.13	5.45	2.8385
Mid-Cap	20.27	24.70	16.78	7.92	2.5593
Value	17.41	21.48	13.43	8.05	2.1627
Sector – Financial Services	14.12	18.95	12.36	6.59	2.1426
Multi-Cap	18.28	23.94	14.94	9.00	2.0311
Large-Cap	13.77	17.82	11.04	6.78	2.0310
Contra	16.97	20.75	12.31	8.44	2.0107
Equity- Infrastructure	17.83	23.25	12.68	10.57	1.6868
Small-Cap	22.43	29.97	15.92	14.05	1.5964
Focused Fund	15.53	20.93	10.99	9.94	1.5624
Large & Mid- Cap	16.91	24.54	13.02	11.52	1.4679
ELSS (Tax Savings)	16.05	25.09	13.37	11.72	1.3695
Flexi Cap	15.69	23.64	10.63	13.01	1.2060
Median	16.48	22.37	13.08	8.72	2.0208

Data Source: Morningstar India

Here are some of the key takeaways from the risk adjusted returns on equity funds over the last 10 years.

• The median returns of equity funds as a category have been 16.48%, indicating that equity as an asset class has delivered the returns over a 10-year period.

   

• Even if you look at the median bottom returns for equity funds as a category, it comes to 13.08%. Which means even the worst performer in equity funds have done better than other asset classes on CAGR returns over 10 years.

   

• Let us look at the top performers in equity funds category on risk adjusted returns. Surprisingly, it is dividend yield fund that have done the best on risk adjusted returns over the last 10 years. Not only have such dividend yield funds performed well due to the dividend support, they have done so with low levels of volatility. 

   

• Among other top performers were healthcare and mid-cap fund categories. Healthcare, in the last 10 years, gained from two major bull rallies. First was the rally from 2012 to 2015, when gains of the expansion started trickling in. Second was the rally post COVID. Mid-cap funds also did very well, with the attractive returns of over 20% CAGR over the last 10 years, more than offsetting the higher levels of risk.

   

• Finally, for the laggards in the segment in terms of risk adjusted returns. Flexi-cap funds have shown the lowest performance, clearly showing that discretion to fund manages is not really scoring over a rule-based approach. ELSS funds have been consistently doing below-average while in the case of Large & Mid-cap funds, the returns are not commensurate for the higher levels of risk.

Overall, the risk-adjusted story is quite compelling. Over the longer run, it is not just the returns, but it is the risk factor that makes a bigger difference. That is where, the likes of Dividend Yield funds and healthcare funds have scored.

How Income Funds performed over 10 years on risk-adjusted returns

The table below captures the performance of various categories of income / debt funds based on risk adjusted returns.

Morningstar  Category	Category Average	Top Performer	Bottom Performer	Range Variance	Risk Adjusted Returns
Long Duration	6.59	8.71	5.47	3.24	2.0340
Floating Rate	6.32	8.18	4.55	3.63	1.7410
10 yr Government Bond	6.74	8.80	4.68	4.12	1.6359
Medium to Long Duration	6.32	8.57	4.04	4.53	1.3951
Short Duration	6.21	8.68	3.90	4.78	1.2992
Banking & PSU	6.25	8.92	4.06	4.86	1.2860
Medium Duration	6.61	9.60	3.67	5.93	1.1147
Corporate Bond	6.51	9.38	3.23	6.15	1.0585
Ultra Short Duration	5.65	8.61	3.09	5.52	1.0236
Money Market	5.75	8.79	3.16	5.63	1.0213
Government Bond	7.20	9.75	2.37	7.38	0.9756
Low Duration	5.69	8.06	2.08	5.98	0.9515
Credit Risk	6.00	9.00	2.40	6.60	0.9091
Dynamic Bond	6.66	9.83	0.23	9.60	0.6938
Median	6.32	8.80	3.45	5.58	1.0866

Data Source: Morningstar India

Here are some of the key takeaways from the risk adjusted returns on income / debt funds over the last 10 years.

• The median returns of income / debt funds as a category have been 6.32%, indicating that bonds as an asset class have done below par, considering their unfavourable tax treatment. 

   

• If you look at the median bottom returns for income / debt funds as a category, it comes to 3.45%. That would classify as returns less than the rate of inflation, so fund selection becomes a lot more critical in the case of these income / debt funds.

   

• Let us look at the top performers in income / debt funds category on risk adjusted returns. The top 3 performers on risk-adjusted returns are from the opposite side of the spectrum. There are long duration funds and floating rating funds in the top list, showing that over a longer period of time, rate movements tend to get neutralized.

   

• What are the at the bottom of the heap when it comes to risk adjusted returns in income / debt funds? Thematically, the low performers are a mix of discretion and credit quality. Credit quality funds being at the bottom of the heap is hardly surprising. However, what is also surprising is that dynamic bond funds have been the worst performers in terms of risk-adjusted returns in income funds and this is largely because, the incremental benefits of fund manager discretion are not commensurate with the higher risk caused by volatility.

In the case of debt funds, discretion and credit quality have worked against performance. However, an interesting takeaways is that over the longer time frame, it does not add a lot of value trying to predict which way the interest rates are likely to move. 

How Alternate Funds performed over 10 years on risk-adjusted returns

The table below captures the performance of various categories of alternate funds based on risk adjusted returns.

Morningstar  Category	Category Average	Top Performer	Bottom Performer	Range Variance	Risk Adjusted Returns
Sector – Precious Metals	6.21	6.27	5.01	1.26	4.9286
Balanced Allocation	10.34	11.89	9.01	2.88	3.5903
Arbitrage Fund	5.87	6.78	3.71	3.07	1.9121
Dynamic Asset Allocation	11.77	17.42	9.14	8.28	1.4215
Equity Savings	8.03	10.89	4.53	6.36	1.2626
Aggressive Allocation	14.10	19.29	8.02	11.27	1.2511
Conservative Allocation	7.64	11.46	3.61	7.85	0.9732
Liquid	5.19	7.00	1.39	5.61	0.9251
Median	7.84	11.18	4.77	5.99	1.3420

Data Source: Morningstar India

Here are some of the key takeaways from the risk adjusted returns on alternate funds over the last 10 years. In this category, we have combined all allocation funds, special situation funds and even commodity funds.

• The median returns of alternate funds as a category have been 7.84%, which could be misleading per se as this is an extremely heterogenous group of asset classes.

   

• Even if you look at the median bottom returns for alternate funds as a category, it comes to 4.77%. That means, these funds have not been able to beat inflation in a worst case scenario, and that is where the equity story assumes significance.

   

• Let us look at the top performers in alternate funds category on risk adjusted returns. There are not two questions as gold funds lead the other alternate asset classes by a margin. This could be partially because the last 10 years have been the phase post the global financial crisis and the European crisis and during this phase, gold did see some very interesting demand indicators.

   

• Among the other key top performers, the focus is once again on a tinge of conservatism. Balanced allocation funds and arbitrage funds are largely conservative funds. The former is more a rule-based allocation fund while the latter only leverages on the arbitrage spread between cash and futures. Focusing on reducing risk has helped here also.

   

• Finally, for the laggards in the segment in terms of risk adjusted returns. At the bottom are the liquid funds, aggressive allocation, and conservative allocation funds. Now that is ironical, but let us understand this logic. Conservative allocation has a problem with returns while aggressive allocation has a problem with risk. A more rule-based Balanced allocation has done a lot better.

To sum up the story of mutual fund rankings over a 10-year period on risk adjusted returns; dividend yield funds emerged as the best category across the spectrum on risk-adjusted returns followed by gold funds. Clearly, conservatism and prudence are working well in mutual funds in India.