How risky is your mutual fund?

nvestors always judge a fund by the return it gives, never by the risk it took.

In any historical analysis of a mutual fund, the return is remembered but the risk is quickly forgotten.

So a fund manager may have used very high-risk strategies (that are bound to fail disastrously in the long run), hoping that his wins will be remembered (as they often are), but the risk he took will soon be forgotten. 

Yesterday we carried a piece on how to evaluate returns from a mutual fund.

Today, let's talk about risk.

What is risk?

Risk can be defined as the potential for harm.

But when anyone analysing mutual funds uses this term, what is actually being talked about is volatility.

Volatility is nothing but the fluctuation of the Net Asset Value (price of a unit of a fund). The higher the volatility, the greater the fluctuations of the NAV.

Generally, past volatility is taken as an indicator of future risk and for the task of evaluating a mutual fund, this is an adequate (even if not ideal) approximation.

How risk is measured

There are two ways in which you can determine how risky a fund is.

- Standard Deviation

Standard Deviation is a measure of how much the actual performance of a fund over a period of time deviates from the average performance.

Since Standard Deviation is a measure of risk, a low Standard Deviation is good.

- Sharpe Ratio

The Sharpe Ratio of a fund measures whether the returns that a fund delivered were commensurate with the kind of volatility it exhibited.

This ratio looks at both, returns and risk, and delivers a single measure that is proportional to the risk adjusted returns.

Since Sharpe Ratio is a measure of risk-adjusted returns, a high Sharpe Ratio is good.

How to check the fund's risk

So how would you figure out how risky a mutual fund is?

Value Research, a mutual fund research outfit, carries out a rating every month which is also carried on rediff.com. If you would like to take a look at the latest ratings, click on the relevant month: March, April, May.

In this rating, each fund is given a star. The funds with a 5-star rating are the best. Those with a 1-star rating are the worst.

This star rating is based on risk-adjusted return. In a very simple way, it gives investors an understanding of whether a fund is taking an acceptable amount of risk in generating the kind of returns it is doing.

A fund's return for each month is taken since the day it is launched (only funds with a minimum performance of history of three years are considered).

This return that a fund gives is compared to other 'riskless' investments, like government investments, which have no risk per se. This means funds do not rate very high if they give phenomenal returns, but have taken tremendous risks to do so.

What you must note

1. Don't just look at the NAV, also look at the risk

Alliance Buy India and Alliance Equity both have 3 stars. That does mean their NAV is identical. In fact, the NAV of Alliance Equity is 91.66 while that of Buy India is 16.05.

However, Alliance Buy India took an average risk and delivered an average return, while Alliance Equity took an above average risk to get the above average returns. Hence their stars are identical, depiste one having a higher NAV.

2. Higher rating does not mean better returns

A fund with more stars does not indicate a higher return when compared with the rest. All it means is that you will get a good return without putting your money at too much risk.

Birla Equity Plan has a 4-star rating while Alliance Tax Relief '96 has a 2-star rating. However, the fund with the 2-star rating has a higher NAV (131.96) than the one with the 4-star rating (39.37).

3. Higher rating does not mean more risk

Birla Advantage has an NAV of 67.09 while Franklin India Prima has an NAV of 122.92.

This does not necessarily mean that Franklin India Prima is offering a higher risk since the return is higher.

In fact, according to our ratings, Franklin India Prima is a 5-star fund while (risk is below average) while Birla Advantage is a 2-star fund (risk is above average).

On a final note

When you decide to invest in a mutual fund, you must look at risk and return.

Always ask yourself one question: What are the chances of my losing money?

Do not get misled by high returns. You could also end up losing a substantial part of your savings.

Note: All NAVs are as on June 20, 2005.