Tuesday, January 26, 2016

How do you compare the risks in different equity funds

Equity funds are riskier than debt funds - that is well known. However, between two equity funds, how do you know which of the two is riskier? To know more, read the article here, published in Mid-day Gujarati edition today:


Read the English translation of the same here:

Most discussions about mutual funds are consistent in that equity funds are riskier than debt funds. What do we mean by this? What is this risk?
A lot of investors equate this risk with loss of capital. However, in investment theory, most often, the risk on a portfolio is represented by volatility in the market value of the portfolio. in case of a mutual fund (which is also a portfolio), the volatility in market value is equal to the fluctuation n the fund’s NAV.
So the meaning of the phrase “equity funds are riskier than debt funds” is that “the NAV of an equity fund would be more volatile than that of a debt fund”.
While looking at the portfolio risk, the theorists do not look at the risks that can be removed or reduced through diversification. The volatility in market prices is one risk that cannot be diversified away and hence the discussion is centered around only one risk. As mentioned earlier, it is well known and accepted that equity funds are more volatile than debt funds. Hence, we would only discuss the risk of price volatility of equity funds.
Then the question is: between two different equity funds, how do we know which one is more risky and which is less risky?
There are two important parameters one can look at, viz., standard deviation and portfolio Beta. Both are statistical terms to measure volatility of the scheme’s returns. In both cases, normally the monthly scheme returns are tabulated and then the variation in these monthly returns is measured.
Standard deviation is a measure of variation of various monthly returns round the average of all these monthly returns. Beta, on the other hand, measures the volatility of a scheme’s returns as compared to that of its benchmark.
Standard deviation is a number above zero – a positive number. Higher the standard deviation, higher the risk of volatility. If scheme A’s standard deviation is 25 and that of scheme B is 18, than scheme A is considered to be riskier than scheme B.
Beta would also be a positive number. However, it is always in reference to its own benchmark (in other terms, in relation to the market). A Beta of 1 means the scheme is as risky (or volatile) as the market itself. Beta lower than 1 indicates a scheme that is less risky (volatile) compared to the market and Beta higher than 1  indicates the scheme is riskier (more volatile) than the market.
Both these numbers are available in the fact sheet of most of the funds. If these are not available in the fact sheet, you may check with some of the popular websites, where such data would be available.
Caution: Both these numbers are calculated for the past, and hence they may change over time. Having said that, these still are good indicators to compare different schemes.
Investors, who are risk takers, may prefer schemes with higher standard deviation or schemes with Beta above 1. On the other hand, conservative investors may look for schemes with lower standard deviation or those with Beta less than 1.
Choose your schemes wisely.
-        Amit Trivedi
The author runs Karmayog Knowledge Academy. Recently, Amit has authored a book titled “Riding the Roller Coaster – Lessons from Financial Market Cycles We Repeatedly Forget”. The views expressed are his personal opinions.

1 comment:

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