Understanding risk-adjusted returns

How do you know whether you are compensated enough for the risk taken? Read my article to find out ...

http://epaper.gujaratimidday.com//epaperpdf/gmd/08022016/08022016-md-gm-12.pdf

The English translation is as under:

Risk-adjusted returns

Last time, we saw standard deviation and beta as measures of risk to compare two or more equity funds. These parameters measure the risk of volatility involved in the equity funds. This volatility could be on account of various factors. However, in most cases, the fund managers take the risk of volatility with an objective to generate high long term returns.

In such a case, it may not be proper to look at returns or risk in isolation. It would be prudent to see if the risk has been duly rewarded or not. Did the fund manager succeed in generating high returns for taking on higher risk?

Investment managers evaluate this question through what is known as “risk-adjusted return”. There are various ways to measure this parameter. The most popular among these is known as “Sharpe ratio”, named after Economist William Sharpe.

Assume there is an investor, who does not want to take any investment risk. Such an investor would have to be satisfied with “risk-free” rate of return. However, in order to earn higher than the “risk-free” rate, one will have to take some risk. Since we are discussing equity funds (a well-diversified equity portfolio) here, the only risk to consider is volatility. Now, by investing in equity fund, the fund manager has taken the risk of price volatility or fluctuations. Is he able to get returns higher than the risk-free rate? If yes, how much? This is what Sharpe ratio captures.

The equation for calculation of Sharpe ratio is as under:

Sharpe ratio = (portfolio return – risk-free rate) / standard deviation of the fund

Higher Sharpe ratio is considered to be better than a lower ratio, as the fund manager rewarded the investors for the risks taken.

As can be seen from the above equation, the excess return generated by the fund is in the numerator, whereas the standard deviation (as we saw last time, standard deviation is a measure of volatility – higher SD means higher risk) is in the denominator.

Higher standard deviation would reduce the Sharpe ratio. So, if the fund manager who takes higher risks gets a lower score. Similarly, higher returns would increase the Sharpe ratio. Thus, someone who can generate higher returns by taking lower risk would have a better Sharpe score compared to others. However, someone generating higher returns by taking high risk might get a similar score as someone who generates lower returns by avoiding risks.

Let us also understand that the numerator is excess return over risk-free rate and not just the return generated by the fund. Even if the fund has generated positive but less than risk-free return, the Sharpe ratio would be negative. This also means that the fund manager could not even generate risk-free returns in spite of taking the risk. Due to this, Sharpe ratio is not always the best indicator since when the overall market is down, most equity funds would also deliver negative or low returns. In such a case, the Sharpe ratio would be negative. Please do not judge this as incompetence of the fund manager. It would be prudent to compare two similar funds on this scale rather than looking at the Sharpe ratio of one fund and arriving at a conclusion.

-        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.

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:

http://epaper.gujaratimidday.com//epaperpdf/gmd/25012016/25012016-md-gm-14.pdf


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.