The Hindu Business Line : Mutual funds: When risk enters the performance equation

Business Line uses various metrics to analyse the performance of 27 diversified equity funds with a long track record to assess their risk-adjusted returns over the volatile market conditions of the past three years.

Selecting the right mutual funds for one's portfolio has become quite a challenging exercise in recent times. Not only are equity funds having greater difficulty in beating their benchmarks, funds that do well in a secular bull market often do not deliver in bearish or volatile market conditions. This is why evaluating a fund's performance on returns alone may not give you the correct picture on the best funds for your portfolio; you need to find funds that deliver the best returns for the risk they assume. To help in this exercise, Business Line analysed the performance of a representative sample of 27 diversified equity funds with a long track record to find out how they fared on risk-adjusted returns over the volatile market conditions of the past three years.

Reshuffle in rankings

The diversified equity funds in the our sample recorded absolute returns of 105-298 per cent over the three-year period to March 2007. Ranking the 27 equity funds by performance based only on their point-to-point returns over this period, Magnum Multiplier Plus, Magnum Contra and PruICICI Dynamic Plan were among the top performing equity funds, each of these notching up a threefold appreciation in value.

However, the rankings of the top 10 do undergo a reshuffle if the evaluation is on a risk-adjusted basis, rather than on returns alone. Magnum Contra Fund was the top performer based on absolute returns. But it appears to have assumed higher levels of risk to produce the returns and, therefore, figured in the second slot in terms of risk-adjusted return, in comparison to Magnum Multiplier Plus. Similarly, Templeton India Growth generated only marginally higher returns than Principal Resurgent India, but fared much better than the latter on risk-adjusted returns. Kotak-30, which was on a par with Kotak Global on returns alone, slips when one compares the risk-adjusted return.

Sharpe ratio

The first measure considered to evaluate risk-adjusted performance of the equity funds was the Sharpe ratio, a metric that evaluates the return generated by a mutual fund per unit of risk assumed. To calculate the Sharpe ratio, the daily returns of the BSE Sensex were deducted from the daily returns of the equity scheme. The average of this series of daily differential returns was divided by the standard deviation to arrive at the Sharpe ratio.

Only seven of the top 10 performers based on absolute returns remained in the top 10 slots, if the universe of funds was ranked on the basis of their Sharpe ratios. Magnum Multiplier and Magnum Contra, which were far ahead of the rest, followed by Birla Sun Life Equity Fund and HDFC Equity Fund, are diversified funds that had the best track records on delivering risk-adjusted as well as absolute returns over the past three years.

However, Reliance Vision Fund and ICICI Pru Dynamic Fund figured lower in the Sharpe ratio rankings compared to their absolute return rankings. Kotak Global India, HDFC Top 200 and Tata Pure Equity Fund, which did not figure in the top 10 based on absolute returns, acquitted themselves much better when evaluated on their Sharpe ratios. This is sign that though these funds did not match up to the top performers based just on appreciation in their NAV, they nevertheless managed to contain the swings in their NAV better than many of their peers.

The Sharpe ratio captures the returns delivered by a fund per unit of risk assumed. However, the only pitfall of using the ratio is that it factors in upside as well as downside volatility into the definition of risk. While an investor may be quite comfortable with the former, it is the latter he would usually try to avoid.

Treynor's index

It may thus be a good idea to use this ratio in conjunction with other measures, such as the Treynor's index.

Treynor's index is another measure of risk-adjusted performance. The key difference between the Treynor's index and the Sharpe ratio is that the former uses a fund's beta instead of the standard deviation of its returns to factor in its risk profile. Generally, equity funds that turned up at the top of the rankings on Sharpe ratio also did equally well on the Treynor's index.

Magnum Multiplier 93 and Magnum Contra were, once again, the top performers based on the Treynor's index and fared significantly better than their peers on this measure. Kotak Global, Birla Sun Life Equity and HSBC Opportunities also figured high in the rankings on this measure. Kotak-30, a diversified fund with a large-cap bias, was the new entrant to the top ten rankings based on the Treynor's measure.

The majority of the diversified equity funds ranked carried a beta of slightly less than 1, a sign that fund NAVs move mostly in step with the market.

A few funds in the sample, however, recorded a beta of more than 1 for the three-year period — ICICI Pru Dynamic Fund and ICICI Pru Growth. Magnum Contra, Kotak Global India and DBS Chola Opportunities are noteworthy for their relatively low betas (of 0.75-0.83).

This could suggest that equity funds may be less vulnerable to a fall in the indices today, compared to a year ago; but the flip-side could be that participation in any upside would also be lower.

Highest Alpha

Finally, on to the Alpha, the measure that calculates the value added by the fund manager of an equity fund, to pure market returns. Predictably, given their high absolute returns and good risk-adjusted showing, the Magnum twins — Contra and Multiplier Plus — recorded the highest alpha generation over the three-year period.

However, other top rankers, such as Birla Sun Life Equity, Kotak Global, Tata Equity Opportunities, HDFC Equity and Franklin Prima Plus, also generated high alpha, adding significant value for their investors. The Principal Resurgent India was the only scheme to report a negative alpha from the list of 27 schemes.

The right combination

No matter what parameters are used, however, it is difficult to recommend one set of funds as suitable for all investors. Instead, investors have to choose products that best fit their risk appetite and time horizon. Based on the analysis, a combination of the Treynor's measure and alpha may be more appropriate in choosing the best funds.

Since beta is the denominator for Treynor's index, if the fund assumes more risk there is a possibility of a drop in the index, unless it really outperforms the benchmark.

PruICICI Dynamic is a clear example of this. Despite its higher beta and higher standard deviation, the fund boasts a better alpha over the past three years.

At the other end of the spectrum, Principal Resurgent India, which has the same standard deviation and beta as PruICICI Dynamic Fund, does not measure up in terms of Alpha. Based on the analysis, funds such as Magnum Multiplier 93, Magnum Contra, PruICICI Dynamic, HDFC Equity, Birla Sun Life Equity, Franklin India Prima Plus, Kotak Global and DSPML Equity appear to be good investment options for the long term.

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