Assess risks, not just past returns

MUMBAI: Risk is one factor that often gets ignored while evaluating the returns of a mutual fund’s scheme. A fund might yield the best of returns during a bull market by adopting an aggressive investment approach, but could end up losing it all when the market falls. This means that the returns could be highly inconsistent and volatile, which can be unnerving for investors.

Though a certain amount of risk cannot be ignored, while investing in schemes with higher returns, investors can use some risk-return measures to weigh investment options. A measure that evaluates both risk and returns among schemes or funds is the Sharpe Ratio. A positive and higher Sharpe Ratio shows a better risk-adjusted performance of a fund. An analysis of 161 diversified-equity schemes by brokerage Sharekhan evaluates the returns, risk and stock-picking ability of each of these funds for August.

Most diversified-equity schemes gave an average return of 7-14% during August. While the highest Sharpe Ratio was between 0.6 and 0.7, the lowest was 0.3 to 0.4 (3 funds registered negative Sharpe ratio too). Theoretically, a Sharpe ratio of above 0.6 is considered good.

Some of the schemes, which gave the highest returns during the month, were Taurus Discovery Stock (18%), Reliance RSF-Equity (14.5%), Prudential ICICI Fusion Fund - IP (13.15%), Prudential ICICI Discovery Fund - IP (12.87%) and Franklin India Opportunity Fund (12.62%), according to the study.

On the face of it, the returns might look impressive in isolation, but the risk factor has not be factored in. This is where, the Sharpe Ratio comes in the picture. The Sharpe Ratio for Taurus Discovery Stock, which gave the highest return in the month, was 0.5226, Franklin India Opportunity Fund was 0.4787, Prudential ICICI Fusion Fund-IP was 0.5077, Reliance RSF-Equity was 0.6870 and Prudential ICICI Fusion Fund - IP was 0.6391.

So here, it can be noted that Reliance RSF Equity and Prudential ICICI Fusion Fund-IP have managed to be the better performers, as far as risk-return measure is concerned.

Another measure showing whether a scheme has posted superior returns vis-a-vis risks is Eugene Fama model. This measure is used to calculate the scheme’s ability to post returns in proportion to the risks and the extent of diversification by the fund to post the return. Higher the Fama, better is the stock-picking ability of a fund. In August, 84 out of the 161 schemes showed a negative trend as per the Eugene Fama model.