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Session 16: Analysing Risk Return and Performance of Mutual Funds

We are glad to have you with us for our Sixteen Session - Analysing Risk Return and Performance of Mutual Funds.

Alright so now let's get started with our learning session today and let us understand the various parameters that can help you analyse risk and evaluate the performance of mutual funds.

Evaluating Risk-Return is the primary step towards investing in mutual funds. You see, as other investment avenues carry risk, even mutual funds carry risk while they endeavour to create wealth for their investors in the long run. Hence you should choose mutual funds based on your risk tolerance level and return expectations. In today's session we will tell you how you can balance your risk and return with appropriate tools and data available, while you invest in mutual funds. Also while identifying and finalising the right mutual funds for your portfolio, you should make sure that they match your risk tolerance level and return expectation.

So what are some of the major...

Risks Associated With Mutual Funds

  • Market Risk - Mutual Fund investments are subject to market risk, as the underlying investments where mutual funds invest - such as stocks and bonds - show uncertain movement. Do not forget the prices of these underlying instruments are driven by market sentiment and over a time period it may lead to volatility in the performance of the funds.

  • Industry Risk - Any negative news / development in a particular industry may lead to a fall in stock prices for that particular industry, and therefore may impact the valuation of funds with a concentration towards such an industry.

  • Country Risk - Country specific risk may have an impact on financial markets. This can be due to economic factors such as inflationary pressure, sovereign risk - i.e. default by government, etc; or even political events such as general elections, administrative functioning, policy decisions; or even natural disasters such as earthquake, flood, etc. All these may have a high impact on the performance of funds focusing towards any such country.

  • Currency Risk - A swift upside or downside movement in currency may impact one's investment in offshore instruments. An Indian investor investing in a U.S. focused fund may earn high return in a scenario where the Indian Rupee suffers a huge depreciation against the U.S. dollar and vice versa.

  • Interest Rate Risk - Interest rates and bond prices are inversely related. Any upside movement in interest rates may lead to downside movement in bond prices and thus impact its portfolio valuation, especially debt portfolio and debt mutual funds. However the impact of this risk may fade over time.

  • Credit Risk - Also known as default risk arises when a bond issuer fails to meet his obligation of timely interest payment or principal repayment.

  • Principal Risk - Any near term volatility or swift fall in prices of underlying instruments may lead to depreciation in fund value to levels even lower than the original investment. This may cause principal risk for investors.

  • Fund Manager Risk - Fund manager risk can be experienced when the fund manager fails to execute the fund's investment strategy or meet its investment objective. Also a frequent change in fund managers may lead to such risk. However process driven fund houses are well placed to avoid such risk for its investors.

So you see, it is imperative for investors to identify mutual funds that can help them meet their investment objectives at the desired risk level. And mind you, gauging risk in a mutual fund scheme only on the basis of the NAV of the fund reports may not be a holistic assessment. It is noteworthy that, in a rising market, it is not altogether difficult to clock higher growth if the fund manager is willing to take higher risk. We have seen this on several occasions in the past - during the tech rally of 1999 and early 2000, as well as several mid cap rallies of the past.

So, assessing the past returns clocked by the mutual fund in isolation will be inaccurate, because they do not give you any indication of the level of risk you have been exposed to as an investor.

So here are the...

Indicators for Measuring Mutual Fund Risk

  • Standard Deviation (SD) - is the measure of risk taken by, or volatility borne by, the mutual fund Mathematically speaking, SD tells us how much the values have deviated from the mean (average) of the values. SD measures by how much the investor could diverge from the average return either upwards or downwards. It highlights the element of risk associated with the fund and is calculated by using historical NAVs of the scheme. Higher SD indicates that the scheme carries high risk for investors. So if 2 schemes have generated identical returns, then you should choose the scheme with the lower SD, as it has managed to deliver returns at relatively lower risk.

  • Beta - is a measure of the volatility of the scheme in comparison to the market indices Beta shows the extent to which the return of the scheme is impacted by market factors. Say a scheme's beta of 1.0 vis-à-vis the benchmark index like CNX Nifty will indicate that the scheme's risk is in line with the Nifty index, and will move in tandem with the index. A beta of less than 1.0 will indicate that the scheme is less volatile than the benchmark index; while beta of more than 1.0 will indicate that the scheme is more volatile than the benchmark index.)

  • R-Squared - It measures the correlation between the scheme's beta and its benchmark index and ranges between 0 and 1. ...While 0 represents no correlation, 1 represents full correlation. A fund with low R-Squared means the fund will not give returns similar to its benchmark index, while R-Squared of an index fund (replicating a particular index) would be around 1 and may give returns in line with the benchmark index.

  • Duration - It measures a bond's sensitivity to changes in interest rates In simple terms, duration shows the change in value of fixed income instrument that will result from a 1% change in interest rate. Longer the duration of a bond, higher the sensitivity and vice versa. The sensitivity of a debt mutual fund scheme to interest rate changes can be determined from its average duration. It can help you measure the level of interest rate risk you are exposed to, by holding the fund. If you have a low risk appetite, debt funds with higher duration may not be suitable for you.

    You see, below the historical returns of a mutual fund scheme, it is usually stated that, "past performance may or may not be sustained in future and should not be used as a basis for comparison with other investments". This disclaimer is explicitly stated, whenever fund houses mention the past performance of a scheme. A reason why past performance is not entirely representative of a mutual fund's 'good showing' is because: it does not take into consideration the performance of its peers. It is possible that a fund has performed reasonably well (across relevant parameters) by itself, but hasn't quite made the mark when compared to its peers. So let us now take a look at the parameters that may help you compare the returns and performance of a mutual fund scheme with its comparable peer group, and help you assess whether or not you should invest in it.

Calculating Mutual Fund Returns

  • Absolute Returns - are the simple returns ...i.e. the returns that an asset achieves, from the day of its purchase to the day of its sale, regardless of how much time has elapsed in between. This measure looks at the appreciation or depreciation that an asset - usually a stock or a mutual fund - achieves over the given period of time. Mathematically it is calculated as under:

    (End Value - Initial Value) X 100
    Initial Value

    Generally returns for a period less than 1 year are expressed in an absolute form.

  • Annualised Return - shows the average annual return on investment over a period of time ...It means if you earn an absolute return of 100% over a period of 5 years, then your annual return would be 20%. i.e. 100/5. Annualised return may not exactly indicate the annual growth you get on your investment.

    And hence you should consider...

  • Compounded Annual Growth Rate - CAGR can show you the year-on-year growth rate of your investment over a period of time ...It can give you a better idea about the past performance of any investment. While selecting a mutual fund scheme one should look for and compare the scheme based on long term performance. The long term growth of a mutual fund scheme vis-à-vis its peers over a longer time period of say 3 years or 5 years, should be calculated in terms of CAGR.

    Mathematically CAGR is calculated as:


    For calculating CAGR you need to consider your fund's end value, your initial investment value and the number of years of your holding.

  • Dividend Payout and Distribution of Bonus - ...Not the least, while considering the return of a mutual fund scheme over a particular time frame, you should also account for all the Dividends and Bonus that have been distributed by the scheme in that time period. This point is relevant for investors looking to invest in a Dividend option of the scheme, as here it is imperative to calculate dividend-adjusted returns and / or bonus-adjusted returns.

Calculation of Returns

  Value (Rs) Absolute Return (%) Annualised Return (%) CAGR (%)
Year 0 1,00,000 - - -
Year 1 1,10,000 10.0 10.0 10.0
Year 2 1,20,000 20.0 10.0 9.5
Year 3 1,30,000 30.0 10.0 9.1
Year 4 1,40,000 40.0 10.0 8.8
Year 5 1,50,000 50.0 10.0 8.4
(This return calculation table is for illustration purpose only)

The table shows the return calculation on an investment amount of Rs 1,00,000 over a period of five years. We can see that absolute returns keep on increasing with an increase in value. And even if the annualised returns for all the five years are the same i.e. 10%, the CAGR reduces gradually. So, different methods of return calculation can project different returns. Before falling in for any investment option showing you high returns, you need to check whether the returns are calculated in absolute terms or annualised or CAGR. You should always compare returns by applying the same method of calculation.

Making your investment decision by considering only historical returns and dividends in a mutual fund scheme can be risky. As we mentioned earlier, as an investor you need to also evaluate the risk involved in a mutual fund scheme before investing. But evaluating the investment option on any one of the two, i.e. risk or return on a stand-alone basis, will not be a prudent assessment. Hence before making any investment, the mutual fund scheme must be evaluated based on the risk-return criterion.

Indicators for Measuring Mutual Fund Performance based on Risk Return Parameters

  • Sharpe Ratio - A measure developed to calculate risk-adjusted returns Sharpe Ratio measures how much return you can expect over and above a certain risk-free rate (for example, the bank deposit rate), for every unit of risk (i.e. Standard Deviation) of the scheme. Statistically, the Sharpe Ratio is the difference between the annualised return and the risk-free return divided by the Standard Deviation during a specified period.

    Sharpe Ratio =(Portfolio Return - Risk Free Return)
    Standard Deviation of the Portfolio

    Higher the magnitude of the Sharpe Ratio, higher would be the performance rating of the scheme. So if 2 schemes have delivered similar returns, you should choose the one with the higher Sharpe Ratio, as it has shown its ability to deliver better risk adjusted returns.

  • Treynor Ratio - It measures risk-adjusted return based on systematic risk It is similar to the Sharpe ratio, with the difference being that the Treynor ratio uses Beta as the measurement of volatility, while the Sharpe ratio uses Standard Deviation.

    Treynor Ratio = (Portfolio Return - Risk Free Return)
    Beta of the Portfolio

    A scheme with a higher Treynor Ratio should be preferred as it indicates the scheme has excess return per unit of systematic risk or Beta.

  • Jensen's Alpha - Represents the difference between actual returns of the scheme vis-à-vis the expected returns of the scheme, over a period of time A positive alpha means the fund manager has managed to generate returns in addition to the benchmark index, while a negative alpha means the fund manager has generated returns lower than its benchmark. So we can also say, Alpha indicates the ability of the fund manager to generate additional returns for investors.

Some Key Takeaway Points!

  • (As...) Mutual Funds Carry Risk ( should choose mutual funds based on your risk tolerance level and return expectations.)

  • Interest rates and bond prices are inversely related (...Any upside movement in interest rates may lead to downside movement in bond prices and vice versa)

  • Process driven fund houses are well placed to avoid fund manager risk for their investors

  • Standard Deviation measures the risk taken by the mutual fund scheme

  • (While...) Beta shows the extent to which the return of the scheme is impacted by market factors

  • Longer the duration, higher will be the sensitivity of the bond

  • (Do not forget...) Compounded Annual Growth Rate (CAGR) is a better method to calculate long term growth of a mutual fund scheme

  • (You should...) Always compare returns by applying the same method of calculation

  • Sharpe Ratio is an important Ratio to measure risk-adjusted returns (...of a mutual fund scheme)

  • (While...) Treynor Ratio measures risk-adjusted return based on systematic risk

  • (So...) A scheme with a higher Sharpe Ratio or a higher Treynor Ratio should be preferred for investment

  • Alpha indicates the ability of the fund manager to generate additional returns for investors

So to end our today's learning exercise we now invite you to test your learning by taking up this simple quiz (and win exciting prizes!)

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Disclaimer: The contents of this document are only for informative purposes and are not to be used or considered to be an offer to sell or buy units of Franklin Templeton Mutual Fund schemes. This video is for information purposes only, provided on an 'as is' basis. Nothing in it should be construed as personal financial advice. You are responsible for your own investment decisions and you should seek advice concerning suitability from your investment adviser regarding any of the investments mentioned. The video is for personal non-commercial use only and may not be copied, stored, redistributed or broadcast in any way. We recommend you read the complete Terms of Use.

Mutual Fund Investments Are Subject To Market Risks, Read All Scheme Related Documents Carefully.

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