Risk-adjusted measure -- The uses beyond ranking

Suresh Krishnamurthy

Morningstar's five-star rating on mutual funds is trumpeted about as much as the Mobil Travel Guide's prestigious star awards for restaurants.

But five-star restaurants rarely, if ever, dish up a bad meal. Five-star funds can, and sometimes do, give you fiscal indigestion. -- Agency report on Morningstar ratings

THE agency report on Morningstar cited above in Business Line (July 30) was headlined ``Common MF rating: Misused, misunderstood.'' The agency report suggested that though Morningstar had done a wonderful job in rating funds, consumers misunderstood the ratings to be endorsements.

In India, too, the ranking of funds on a risk-adjusted measure runs the risk of being misunderstood by investors as an endorsement. In fact, even assessments of absolute returns by third-parties have been used by mutual funds in their advertisement campaigns and performance reports, as if they are endorsements to invest.

Consider the case of an investor who made investments based solely on risk-adjusted performance rankings at the end of February. Irrespective of the method followed, the ranking would not have singled out the fund that would lose less value in the next quarter or six-month period. Even had he invested in the funds ranked 1 and 2, he would have lost value substantially. What this suggests is that ranking, or rating, should not be used to select funds in which to invest.

The quantitative measure used in arriving at the risk-adjusted performance is a factor of the fund's investment strategy. Thus, it should not be forgotten that the impact of a particular investment strategy on performance is unlikely to remain constant over a longer period.

For example, the strategies followed by Sundaram Growth, DSP Merrill Lynch Equity and Zurich India Equity have not exactly paid rich dividends in relative terms, though the funds continue to outperform their benchmarks. Still, this strategy, if consistently employed, may pay off in the long term. Similarly, a buy-and-hold strategy that paid off in recent years may not exactly be successful over a longer time-frame. In such a backdrop, ranking of funds does not appear too significant.

Beyond rankings: Does this suggest that quantitative performance measures are relevant only from a historical perspective? On the contrary, the use of quantitative measures does go beyond ranking of funds. While the returns fluctuate, quantitative risk measures have been found to be stable over time in the Western markets. These quantitative measures contain important information content for an investor that can be used to evaluate a particular fund.

The variations in such measures as `alpha' and `beta', if derived over a longer time, would serve to define the character of funds during bull and bear phases. At a time, when mutual funds provide scarce details on their investment strategy, such quantitative measures are a good starting point.

Most mutual funds indicate in their offer documents that they intend to invest for the longer term, though information on investment strategy is usually minimal. These quantitative measures, in addition to portfolio changes, would indicate the strategy followed and serve as a good proxy for what a fund could be expected to do.

A fund with a lower beta is necessarily different from one with a higher beta. The lower beta could stem from the fact that the fund has invested in stocks which themselves have lower risk, or because the fund actively books profits. A fund that constantly books profits promises a deal to a customer which is entirely different from that promised by a fund which has a higher beta and mostly holds on to stocks.

If the fund's lower beta is because of continuous profit-booking, the fund manager's record in actively managing his fund needs to be examined. Whether the fund gained or lost from the re-investment must be assessed over longer periods. This can be ascertained from the alpha figure calculated over a reasonably long period.

Also, investors who are comfortable with the higher risks associated with a buy-and-hold strategy could opt for a fund with a higher beta, which also has a good performance track record. Similarly, investors with a lower risk profile could opt for good funds that regularly books profits.

Such quantitative measures could also prove useful in selecting funds when investing in sectoral equity schemes. Especially in technology-specific funds, the investment strategies of various funds vary. The quantitative measures could prove useful in filtering schemes an investor finds unsuitable. Overall, the measures can be used to select a fund that appeals to an investor's risk appetite.

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Style rotation: For the savvier investor, the quantitative measures could also be used to shift funds in accordance with the stock market trends. Even a long-term investor can shift his preferences based on such trends. Rotation of investment style has gained importance in recent years because of the enormous upheavals in the market.

These days, a bull market does not promise a return of just 40-50 per cent, but over 100 per cent. Similarly, a bear market wipes out a substantial portion of the gains generated in a bull market. The market mood swings appear to be decidedly more pronounced, emphasising the importance of investment style rotation.

For example, in a bear market, a fund with a high beta and relatively passive approach to fund management is quite likely to be hit. This is what happened to ING Growth Fund since February. Similarly, if funds such as Kothari Pioneer Bluechip and Templeton India Growth continue to remain successful in reducing their betas during bearish phases, they would emerge as promising vehicles in a bear market.

Similarly, if the funds floated by Alliance and Birla maintain their strategies, they could be good candidates in a bull phase. Overall, the quantitative measures have important information content that would help an investor evaluate his strategy.