Measuring Risk of Mutual Funds
Risk measurement Tools
There are various risk measuring tools developed by statisticians to measure the risk adjusted return, drawdown and downside risk that help fund managers and investors to identify the funds and construct their portfolio which would minimize the risk. In the past the performance of funds was only measured with the help of rate of return. Markowitz (1952) & Tobin (1958) suggested Mean-Variance to measure volatility in terms of market variability of returns. Treynor (1965), Sharpe (1966) and Jensen (1968) make comparison between the risk adjusted returns of professionally managed portfolios to that of some standard benchmark. Cumby & Glen (1990) and Lahbitant (1995) analyzed that Mutual Funds are under performing to their benchmark. Murthi (1997) identified the problem in performance of traditional tools while constructing appropriate portfolio for investment. So, due to these problems Murthi (1997) introduced Data Envelopment Analysis (DEA) to measure the performance efficiently. In India, Chander (2000) found the Mutual funds outperform while Singh & Singla (2000) found that Mutual funds underperform to their benchmark. Gupta (2001) found that mutual funds are outperformed as well as underperform as compared to their standard benchmark. Galagedera & Silvapulle (2002) found that mutual funds were efficient in terms of returns in long term. Lin and Chen (2008) found the number of mutual funds generate higher return at a given level of risk in the year 2003 than 2001 and 2002. Soongswang & Sanohdontree (2011) found that mutual fund provides varied return.
Types of Risk
Investment in mutual funds carries risk of loss as the portfolio invested
in can make a loss due to several different reasons. These reasons are the
risks that mutual funds are associated with. They are: -
a) Market Risk: - It is the risk that may result in losses for an investor due to the
poor performance of the market. Many factors including natural disasters,
inflation, recession, political unrest and fluctuation of market rates affect
the market. This risk is also known as systematic risk. Diversification of a
portfolio does not help to alleviate this risk.
b)
Concentration
risk: - It is the risk of
concentrating a huge part of one’s investment in one particular scheme. This
can lead to huge profits if lucky and pronounced losses if unlucky.
Concentrating investments heavily in one sector is also risky. Diversification
of portfolio helps alleviate this risk.
c)
Interest
Rate risk: - The interest rate
in the market changes according to the credit available with lenders and the
demand from borrowers. Increase or decrease in the interest rate might lead to
change in the price of securities – impacting the investment portfolio of the
mutual fund.
d)
Liquidity
risk: - It is the risk of
being unable to redeem an instrument without suffering a loss in its value. It
may also occur when buyers or sellers cannot be found for investments. It may
render you unable to redeem investments when you need them most. Some mutual
funds have a lock-in-period which creates this risk. Careful selection of funds
to invest in and diversification of portfolio can help alleviate this risk.
e) Credit risk: - It is the risk that the issuer of the scheme will be unable to pay the interest promised. Usually, agencies which handle investments are rated by rating agencies on these criteria. So, a person will always see that a firm with a high rating will pay less and vice-versa. Debt funds often suffer from credit risk as the mutual fund managers might include poorly rated investments in the portfolio to increase return. Checking the credit ratings of the investment portfolio is a must before choosing a mutual fund scheme.
Risk Analysis of Mutual Funds
Mutual funds operate on various themes which exposes them to different kind
of risks. Although they are professionally managed but element of risk still
remains. These risks can be attributed to economic performance,
diversification, sector growth and individual company performance. Prior to
taking an investment decision, the investor should crosscheck funds’
performance with respect to various risk measures. In this article we will try
to understand the parameters using which funds’ performance is measured and
risk analysis is done. Investors must perform comparative analysis of these
parameters before making an investment decision.
Standard Deviation as a measure of risk
From a statistics standpoint, the standard deviation of a dataset is a
measure of the magnitude of deviations between the values of the observations
contained in the dataset. From a financial standpoint, the standard deviation
can help investors quantify how risky an investment is and determine their
minimum required return on the investment.
Where:
Ri – the return observed in one period (one observation in the
data set)
Ravg – the arithmetic mean of the returns observed
n – the number of observations in the dataset
Sharpe Ratio
Sharpe Ratio of a mutual fund reveals its potential risk-adjusted returns.
The risk-adjusted returns are the returns earned by an investment over the
returns generated by any risk-free asset such as a fixed deposit. However,
higher returns indicate extra risk. Higher Sharpe Ratio means greater returns
from an investment but with a higher risk level. Therefore, it justifies the
underlying volatility of the funds. The investors aiming for higher returns
will have to invest in funds with higher risk factors.
Beta
Beta denotes the sensitivity of the mutual fund towards market movements.
It is the measure of the volatility of the mutual fund portfolio to the market.
When you are looking at the beta of a mutual fund, you are finding out the
tendency of your investment's return to respond to the ups and downs in the
market. Here, the market usually refers to the benchmark index the fund
follows. The beta of the market or benchmark is always taken as 1. Any beta
less than 1 denotes lower volatility and higher than 1 denotes more volatility
compared to the benchmark index.
Where:
Covariance = Measure of a stock’s return relative to that of the market
Variance = Measure of how the market moves relative to its mean
Treynor Ratio
The Treynor ratio, also known as the reward-to-volatility ratio, is a
performance metric for determining how much excess return was generated for
each unit of risk taken on by a portfolio. Excess return in this sense refers
to the return earned above the return that could have been earned in a
risk-free investment. Although there is no true risk-free investment, treasury
bills are often used to represent the risk-free return in the Treynor ratio. Risk
in the Treynor ratio refers to systematic risk as measured by a portfolio's
beta. Beta measures the tendency of a portfolio's return to change in response
to changes in return for the overall market.
