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Assessing risk

The risks in mutual fund investments arise from the probability of a fall in the NAVs, which can be attributed to market risks and company-specific risks.

The risks in mutual fund investments arise from the probability of a fall in the NAVs, which can be attributed to market risks and company-specific risks. Mutual funds aim at eliminating company-specific risks—which are due to labour, cost or technology problems— through diversification, but market risks cannot be eliminated because they stem from macro-economic factors like inflation, interest rates and government policies. Let us look at some methods used to assess the risk profile of a mutual fund.

Standard deviation:

It estimates the total risk (market and company-specific) of a fund by measuring the extent to which the fund return varies across its average return. Such variations increase the probability of loss. The return of a fund is the percentage change in its NAV and it can be calculated on a daily, weekly, monthly or yearly basis. High standard deviation means the periodic returns are fluctuating significantly from the average return and this signifies risk. On the other hand, a low standard deviation implies that the periodic returns are fluctuating near the average return, which minimises the probability of loss. There are no defined high and low values and the statistic is considered relative to other funds in the category.

Beta and R-square:
Beta is a measure of market or systemic risk. It is a relative measure and is calculated with respect to its benchmark. Mutual funds are benchmarked against market indices, equity or debt, depending on the fund type. Beta measures the sensitivity of the fund return with respect to its benchmark return.

The funds with a beta value greater than 1 are considered volatile, those with beta less than 1 are less volatile, and a fund with beta of 1 implies it is moving in complete alignment with its benchmark.

A fund’s beta is reliable only if it is accompanied with a high R-square value (generally greater than or equal to 0.7). R-square explains the extent of change in a fund’s NAV that is influenced by changes in its benchmark. Its value varies between 0 and 1. For example, if a fund has an R-square value of 0.7, it means 70% of the fluctuations in a fund’s NAV are because of the fluctuations in the benchmark. Investors must take note of the value of Rsquare while evaluating the market risk of a fund.

Weighted P/E multiple:
The fund’s risk level can also be gauged by looking at its weighted P/E multiple, which is the weighted price earning ratio of the individual scrips in the fund portfolio. This method is suitable for evaluating equity funds. Funds with weighted P/E multiples greater than their group funds or benchmark are considered risky.

Overall, standard deviation is the most popular method as it includes both market and company-specific risks. These statistics are readily available on various tracking Websites like Value Research and Myplexus and the investors must consider these measures while selecting the funds.

Measuring risk for the Birla Sunlife Equity fund
 Birla Sunlife Equity fund Benchmark BSE 200 Comments
Average monthly returns1.54%1.48%In the past 2 years, on an average, the fund has performed better than its benchmark
Standard deviation7.66%7.49%Measure of total risk. Fund has exhibited higher risk compared with its benchmark
Beta1.005 Measure of market risk. In past 2 years, the fund has moved in line with its benchmark
R-square0.967 Beta is reliable. 96.7% of variations in fund returns are due to variations in BSE 200
Weighted P/E multiple  As portfolio weights keeps varying, it is difficult to compute a stable weighted P/E ratio

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