The one crucial thing that you should NOT ignore while selecting an Equity Mutual Fund:

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Investors lay a lot of emphasis on past returns and star ratings while selecting an equity mutual fund. Some do-it-yourself investors (DIYers) also consider investment objective, fund size, expense ratio, fund house, fund manager, etc. But there is one crucial factor that investors usually ignore in fund selection. In a scheme document or a fund advertisement, the one thing that is always mentioned is “Mutual funds are subject to market risk”. Yes, it is the RISK FACTOR that investors do not consider at all in selecting a fund. You must be knowing that higher the risk, higher the returns. What do you think is better & preferable – 18% returns with acceptable risk or 20% returns with very high risk? Do you know how much risk is your mutual fund taking in generating an X% of return for you?  How will it perform in a falling market? Here are some risk factors you should look at during fund selection.

  • Volatility: One of the key factors in successful mutual fund investing is understanding volatility, i.e., standard deviation. In simple terms, volatility measures the deviation in actual returns from the average return (mean) of a fund. Higher the standard deviation, higher the variation in returns and higher the risk. So, this means your investment has a chance to move either up or down in a much wider band compared to an investment with low standard deviation. For e.g., if a fund has given 15 per cent return with average deviation of 20 per cent, its range of return can vary from -5 per cent to 35 per cent. It is prudent to choose a fund which has got lower volatility.
  • Beta: While volatility is an absolute measure of risk, beta is a relative measure of risk. Beta will tell you how much does your fund change for a given change in the index or benchmark. In other words, it measures a fund’s sensitivity to market movements. The beta of the market/benchmark is 1 by definition. So, a beta of 1 implies the fund movement is identical to the index movement. A beta of 0.9 means the fund is 10 per cent less volatile than the index, while any figure more than 1 is considered more volatile compared to the benchmark.

In addition to the above measures, I am always particularly interested in knowing how a fund performs in a falling market. How well can it manage its downturns? Does it fall more than its peers and the benchmark? The following ratios help me in analysis.

  • Downside Capture Ratio: This is a good measure to evaluate your fund’s performance during bad market periods. So, when the Sensex falls, how much of the negative index returns has your fund captured? How has it performed vis-à-vis the index? For example, if the index falls by an average 15 per cent during a particular period and your fund falls by an average 10 per cent, it means the fund has captured only 66 per cent of the index losses (10/15). The lower the ratio, the better is the downside protection.
  • Sortino Ratio: This ratio will help to know how well your fund has managed to balance risk and return. Even this ratio measures risk by focussing on volatility, i.e., deviation but only negative deviations. This implies that the ratio finds out how often the fund has dipped below its average returns during downturns. It is calculated as the difference between the fund return and risk-free rate (say 10 year govt bond or FD) divided by the average downside deviation. The higher the ratio, the better.

How to use these ratios to shortlist a fund?

You can consider these ratios for comparison with another fund of the same category or benchmark or index. So, suppose, you are holding ICICI Bluechip Focussed Fund, you can compare the above ratios of your fund with other large cap funds like SBI Bluechip, Reliance Large Cap, Aditya Birla SunLife Frontline Equity, etc. You can find out how risky is your fund vis-à-vis its peers and benchmark and whether it is consistently generating higher returns and justifying the risk taken. (Note that these ratios need to be evaluated over at least 3-5 year period).

Where will I find these ratios?

You can find these statistics on ValueResearchonline.  Note that the data has been calculated for the last three years. (You can click to enlarge)

If you want to compare long term fund data over 3 years, then you can check it out on Morningstar.

High risk taken by fund manager doesn’t essentially translate into high returns always. The idea is to shortlist equity funds which bear low risk and still give reasonably high returns compare to their peers and benchmark. These ratios will enable you to do a risk analysis of your funds and help you take a decision whether it is worth taking the risk.

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