Risk-return trade-off works in the long term

One of the most elementary hypotheses in the investing world is the risk-return trade-off.

The trade-off works on the premise that any investor who bears a higher risk is rewarded with better returns i.e. he is compensated for bearing that additional degree of risk.

Most investors take into consideration this trade-off before making their investments. An investor who seeks higher returns would generally venture into the stock markets, while one seeking stable and secure returns is likely to stick to fixed income securities.

Does this hypothesis work at all times and under all conditions? If only that was the case! Ideally in a situation where perfect market conditions exist, the tradeoff should hold good.

But ground realities are fairly different.

A closer look at the performances of various mutual funds (based on the investment objective) will help us support this contention.

Equity funds: High risk, high return?

The objective of an equity fund is to provide capital appreciation over the medium to long-term. Since these funds invest their corpus in equities they are perceived as high-risk propositions, hence the investors are justified in expecting commensurate returns.

Over the three-year period being considered the top diversified equity funds have delivered (32.7% to 20.4%) though the returns' adequacy is questionable. During the same period laggards like Magnum Equity (-13.0%), Canglobal (-5.6%), Birla Advantage Fund-Dividend (-4.7%), Taurus Starshare (-3.5%) have offered negative returns.

Income funds: Growth at lower risk!

On the other hand, income funds whose portfolio comprises of corporate bonds (AAA/P1+/AA+ /AA/AA-) and sovereign rated securities (G-secs) are virtually credit risk free.

However, investors have been rewarded highly for this low risk investment option. Leading income funds have managed to deliver returns in the range of 18.4% to 15.0%.

Die-hard enthusiasts of equity funds can claim that the softer interest rate regime has helped income funds offer attractive returns.

However, this can be contradicted on the following grounds -- if falling interest rates have helped income funds, there have been rallies (bull runs?) over the same period which have helped prop up NAVs of diversified equity funds.

Secondly, since most equity fund managers have active styles of fund management they should be in a position to churn their portfolios and offer significantly better returns.

Finally the degree of asset allocation in equity funds can be scarcely matched by an income fund.

Mr Equity, a high-risk investor is justified in expecting higher returns for the additional risk borne. Loss in the form of capital depreciation, a remote possibility for Mr Debt is an area of concern for Mr B.

Over the past three years, the equity fund investor has every reason to believe that he has been given a raw deal vis-à-vis the income fund investor.

The point of contention is the return premium that equity funds should offer for the additional risk undertaken by the investor. It is here that diversified equity funds have faltered.

Despite the additional risk borne by equity fund investor, relative returns of equity funds (vis-à-vis income funds) continue to be inadequate.

The results stated above seem to suggest that investing in income funds is like enjoying the best of both worlds i.e. low risk and reasonable returns.

So far as the equity fund investors are concerned, the risk-return tradeoff has clearly not worked in the period considered.

But there is another aspect to this story. Leading fund managers maintain that the performance of equity funds should be assessed over a much longer horizon.

The long term view
Top Equity funds vs. Top Income funds

The above table presents a very different picture. When a long-term view is considered, a large number of equity funds have outperformed income funds by substantial margins as against the short-term period when only a handful could achieve this feat.

Returns over this tenure justify the risks borne by the investors. These results are a reflection on the time duration that equity fund investors must consider for their investments to bear fruit.

The bottom line is when you plan to invest in equity funds, take a long term view, really long, something like 5-10 years.