Risk Involved in Mutual Fund: Types and How To Measure

Risk is an unavoidable part of investing. While different investments may fall on different points across the risk spectrum, hardly any investment is risk-free. Mutual funds also carry risk. But first, what exactly is 'risk'? In investing, risk is the other name for volatility or fluctuation in price. An investment that is susceptible to wild swings in either direction is considered to be highly risky. 

Both equity and debt funds carry risk, but debt funds are generally less risky than equity funds. Equity tends to be volatile, especially in the short to medium term. 

Type Of Risks Associated With Different Types Of Mutual Funds 

Equity Mutual Funds

• Market Risk 

Equity funds face the risk of the decline of the underlying market. This is by nature present in any form of equity investment. This means even if the fund's portfolio securities are doing great with no change in their fundamentals, portfolio value might simply decline due to the negative mood of the market. 

• Sector Risk 

Suppose most of an equity fund's portfolio is invested in a specific industry or sector (such as energy, technology, or healthcare). In that case, the fund will be affected by adverse developments in that sector.

• Stock specific risk

As mutual funds might invest in stocks of different companies, they directly inherit the specific risks associated with those companies. Any adverse events related to a company, like management fraud, accounts manipulation, poor results, etc., will impact that particular company's stock, dragging down the performance of the portfolio the fund has invested in. 

• Liquidity risk

Investors of mutual funds with a strict lock-in period, like Equity Linked Saving Scheme (ELSS), often face liquidity risk. This means that you often find it challenging to redeem your investment units without incurring a loss.

Debt Funds

• Interest risk

This debt mutual fund investment risk manifests in varying interest values and haunts investors throughout the investment horizon. We already discussed this in the debt mutual funds chapter. It is mostly rooted in the uncertainties about the capital an investor will likely avail at the end of the investment horizon. If the interest rate changes in an economy, the price of the debt security will also change. For example, when the interest rate increases, the price of the bonds decreases, thus putting downward pressure on the portfolio’s value. 

• Credit risk

This risk in a debt mutual fund investment often occurs when the issuer of the debt securities fails to pay the promised interest. Regarding debt funds, fund managers usually include investment-grade securities with high credit ratings. However, to improve the rate of returns, they might include lower credit-rated securities. This increases the risk of not receiving coupon payments as promised. 

• Inflation Risk

This risk refers to loss of purchasing power, mainly due to the rising inflation rate. For instance, if the rate of returns is 5% and the inflation rate is 3%, investors are left with only 2% returns. Therefore, investors face inflation risk when the rate of returns earned on investments cannot keep up with the rising inflationary rate. 

Index Funds and Exchange-Traded Funds (ETFs)

• Lack of Flexibility

An index fund manager has less flexibility than a non-index fund manager in reacting to the underlying index's price declines. Thus, unlike active fund managers who can react to index movements and have the flexibility to adjust their portfolios, they cannot change the portfolio’s composition. 

• Tracking Error

An index fund may not be able to track its index perfectly. For instance, a fund manager may only invest in some of the securities of the market index; thus, the fund’s performance and index performance might deviate. Tracking errors can also arise due to a lack of liquidity in the underlying securities. 

• No Excess Returns

Index funds and ETFs simply track a benchmark index. Thus, alpha generation has no scope, unlike active funds, as the motive is simply to mimic an index. However, recently, due to financial engineering, smart beta ETFs, which are a blend of active and passive styles of management, have been introduced. You can read more about these ETFs in the ETFs chapter. 

Fund of Funds [FoF]

• Returns Dilution

FoF generally makes more sense for an investor looking to invest only in one fund. This is because a fund of funds holds several funds, and if you have it as just one of your holdings among several funds, you end up being a fund collector. So, it doesn't help and only contributes towards diluting your returns.

• Undesirable Returns

Many FoFs invest only in funds of the same fund company, which is not desirable. So, while you end up investing in many funds, you don't diversify across AMCs. So, FoFs, which invest in funds of the same fund company, score low from that perspective.

• Extra Cost

You add another layer of cost when you're talking about FoFs. This is because you end up incurring the expense ratio of the underlying funds, and on top of it, there is a certain degree of expense ratio that the FoF itself would be charging.

Global Funds 

• Currency risk

As global funds invest in assets denominated in foreign currency, investors in such funds face currency risks. Changes in exchange rates between the countries impact the investor's return. For instance, if the foreign currency falls in value relative to the domestic currency, the returns earned by domestic investors will be less. 

• Country-Specific Risk

Investors in global funds are exposed to the specific risk of the country in which the fund invests. Any instability, political unrest, economic downturns, geo-political tensions, etc., can lead to poor performance of an economy, which will impact the returns of the fund that the economy is part of. 

Riskometer

 

The most basic tool for judging the inherent risk in mutual funds is the riskometer. All mutual fund schemes carry a riskometer pointing to the scheme's inherent risk. Risk-o-metre tells you the risk level of a mutual fund and helps you make better investment decisions by comparing it with other funds that fall under the same category.

As you can see, the risk levels of mutual funds are categorised as Low, Low to Moderate, Moderate, Moderately High, High, and Very High.

History of Riskometer

Introduced in 2015, the riskometer for mutual funds was a simple method to assign risk levels (Low, Low to Moderate, Moderate, Moderately High and High) to funds based on their individual categories. The risk level of each official SEBI category was fixed by SEBI and each fund in that category was simply assigned that risk level automatically. 

How the Risk Level Is Assessed?

In the case of an equity mutual fund, the risk score can depend on the following:

• Market capitalisation: Large cap stocks have lower risk scores than their small cap peers
• Volatility: The greater the fluctuation, the higher the risk score of a stock 
• Liquidity: The risk factor is high if a particular stock is not bought and sold easily in the market due to its low trading volume. 

In the case of a debt mutual fund, the risk score can depend on the following:

• Credit risk: Sovereign and AAA-rated bonds have lower risk value than the lower-rated (riskier) bonds.
• Interest rate risk: The higher the portfolio maturity period, the higher the risk value.
• Liquidity risk: The tougher it is to sell a bond, the higher the risk value.

However, the problem with the riskometer in the case of equity funds is that most equity funds have been assigned a standard 'Very High' risk without considering the fund's basic characteristics, which can mislead you.

For instance, a small-cap fund is far more risky than a passive large-cap fund, but the risk-o-metre fails to capture the difference in risk levels.

Where Can You Find Mutual Fund Risk-related Details on Angel One?

To find details on a mutual fund’s risk:

1. Open your Angel One app and go to the Mutual Fund section.
2. Choose the mutual fund whose details you want to view.
3. Click on the fund name once more, and you will find the detailed fund page.
4. Scroll down to ‘Risk and Ratings’ where you will get all the risk-related information.

Metrics To Measure Risk

When assessing mutual funds' performance, comparing their returns can be misleading. Opting for a fund with the highest returns doesn't necessarily mean it's the best choice. This approach overlooks the vital element of risk. Informed investors often employ ratios and measures of risk to make a more informed judgement, which guides their investment decisions. 

Standard Deviation, Alpha, Beta, etc, are statistical measurements that help investors determine a mutual fund's risk-reward profile. You are not required to calculate these measures separately. Understanding these measures to analyse and interpret them correctly becomes important for you to pick the right mutual fund. The measures discussed in the following discussions are provided on the mutual fund’s website, fund fact sheets, online research websites, etc. 

• Alpha

In the Greek alphabet, "alpha" is the first letter. It symbolises being at the forefront or dominating a field. Applied to mutual funds, funds with the highest alpha provide investors with the most value, especially in actively managed funds. But what exactly does "alpha" signify in the context of mutual funds?

Imagine it's your anniversary, and you eagerly await a special evening with your spouse. You expect a nice dinner, but to your amazement, he sweeps you off your feet with a lavish dinner and a sparkling jewellery set. That is what we call "positive alpha" in investing.

It's the fund that goes above and beyond expectations, just like your thoughtful partner. Now, if he completely forgets about the anniversary and doesn't do anything special, that is what we call a "negative alpha".

Alpha measures a fund's excess returns over its expected returns, accounting for fund management costs. Expected returns, in turn, comprise risk-free returns plus market returns adjusted for the fund's level of risk, as quantified by "beta." The understanding and interpretation of beta are covered in the valuations chapter. 

Alpha measures the value added due to the fund manager's skill. It can be positive as well as negative. And no fund manager would want to have a negative alpha.

Depending on the risk taken by the fund, expected returns are adjusted. A low-beta fund will have lower expected returns than a high-beta fund.

• Understanding Alpha With an Example

Suppose a fund has delivered 20 % returns over the last three years while its benchmark managed only 15% during the same period. Assuming the fund's beta is 0.85, the risk-free rate during that period was 3%. Now we know that the expected return using the Capital Asset Pricing Model is:

Expected return [Ke] = Rf + (Rm - Rf) * Beta

Where:

Rf = Risk-free rate

Rm = Returns from the market 

The expected return would be 13.2% (0.03 + (0.15 - 0.03) x 0.85).
The alpha would be 6.8% (20 - 13.2) in this case.

You, as an investor, always wish to have those funds in your portfolio that have generated alpha consistently. This alpha justifies the extra cost you are bearing, especially in the case of an active mutual fund. However, it is also important to understand that past returns do not guarantee future returns. Chances are there that even funds that have consistently outperformed may underperform.

• Standard Deviation 

Standard deviation measures how much a fund's returns deviate from the mean returns. The higher the value of the standard deviation, the greater the volatility in the fund’s returns. 

For example, A standard deviation of 15 means that the fund’s return can fluctuate in either direction (up or down) by 15% from its average return. These values are annualised and usually updated monthly.

Let's assume there are two funds, A and B. Their monthly returns for the last six months are as follows:

	Fund A returns (in %)	Fund B returns (in %)
Month 1	1.5	6
Month 2	2	-7
Month 3	-0.5	5
Month 4	3	-10
Month 5	-2	12
Month 6	1.25	-.75
Mean Returns	.875	.875
Standard Deviation (Annualised)	6.29	28.98

As you can see, both funds generate the same mean returns. However, a higher standard deviation indicates that Fund B is significantly more volatile and riskier. 

Standard Deviation of Large Cap Funds will be comparatively low compared to Small Cap Funds, which are susceptible to huge drawdowns. Similarly, the Standard Deviation of liquid funds will be much less than equity funds. One drawback of SD is that it takes into account both negative and positive dispersion from the average. Positive dispersion is desirable, while negative dispersion from average is not. So, this ratio must be compared within the same asset class and fund categories and over a similar time frame.

• Sharpe Ratio

The Sharpe ratio is a risk-adjusted measure developed by Nobel Laureate William Sharpe that calculates the mean of a fund’s returns over the risk-free rate. It is a measure of excess returns per unit of risk taken. Excess returns imply the returns a fund generates over and above the risk-free rate. Here, the standard deviation is a measure of risk.

Here is the formula for the Sharpe ratio:

Sharpe ratio = (Fund's return - Risk-free return) / Standard deviation of fund's return

Let's understand the formula with an example:

	Fund C	Fund D
Returns [% P.A.]	18	25
Standard Deviation [% P.A.]	15	30
Risk-free rate [% P.A.]	3	3
Excess returns	15	22
Sharpe ratio	1	0.73

While Fund D delivered a 25 per cent return, it still underperformed compared to Fund C. In contrast to Fund D, Fund C has generated better returns for every unit of risk taken. Therefore, higher returns do not necessarily mean the best mutual fund. If the fund's standard deviation is high, it should justify itself by delivering a better Sharpe ratio. 

The takeaway is that the higher the Sharpe ratio, the greater the returns generated per unit of risk.

• Sortino Ratio

In terms of risk and volatility, an investor will be fine as long their wealth keeps growing. Only when it decreases do they become concerned. Simply put, people are thrilled when there is a bull run but don't care how much their investments go up as long as they move upwards. Investors become nervous and uneasy whenever their money goes down, and the markets become bearish. 

People associate the upside as fun and the downside as risky. Here is where the Sortino ratio comes in. 

The formula for computing the Sortino ratio is 

(Fund's return - Risk-free rate) / Standard deviation of the downside

The Sortino ratio computes the returns per unit of downside risk. Here, the standard deviation can be calculated by taking a sample of instances where the returns are below a threshold. The threshold can be as per one's liking, such as a risk-free rate or a minimum return they prefer for their investments. 

Hence, the higher the ratio, the better the downside risk returns per unit.

• Treynor Ratio 

Measures the fund’s returns (risk-adjusted) per unit of market risk undertaken. It is calculated by deducting the risk-free rate of return from the returns of a portfolio and dividing it by its beta. The higher the ratio, the better the fund’s historical risk-adjusted performance.

Treynor ratio = (Rp - Rf) / Beta 

Where, 

Rp = Mean return of the fund portfolio

Rf = Risk-free rate of return for the time period considered

Beta = Beta of the fund in relation to the benchmark

The formula is quite similar to the Sharpe ratio in the numerator. However, the two are different. Sharpe ratio helps to understand a fund’s return compared to its portfolio risk. In contrast, the Treynor ratio explores the fund’s return generated for each unit of systemic risk of its portfolio. Here, beta is used as a measure of systematic risk as it measures the sensitivity of security with respect to the market benchmark. 

Note on Sharpe Ratio, Sortino Ratio and Treynor Ratio

Please note that you will find all three ratios similar as all measure the risk-adjusted returns. Just the denominator of all three ratios is different. However, the interpretation remains the same - The higher the ratio, the better a fund is on a risk-adjusted basis. 

• Beta and R-squared

Beta and R-squared are two measures best understood together. A fund's beta measures its volatility concerning the market as a whole. Thus, beta measures the fund’s sensitivity to market movements. A beta greater than 1 indicates that the fund is more volatile than the market. If the beta is less than 1, the fund is less risky than the market. If the beta is high, the fund’s return should also be high to compensate for the increased risk. The beta of the market/benchmark is 1. 

For instance, a fund with a beta of 1.3 implies that if the markets go up by 10 per cent, the fund is likely to increase by 13 per cent. Similarly, if the market crashes by 10 per cent, the fund may lose 13 per cent. So, beta can infer whether the fund's returns will be more or less than the market returns.

The calculation of beta is done by referring to the appropriate benchmark. For instance, a beta of a large-cap fund w.r.t small-cap index is meaningless. Hence, using a suitable benchmark is essential. 

This is where R-squared comes in. It tests how reliable the beta is. R-squared can range from 0 to 1. The closer it is to 1, the more reliable the beta is.

For this reason, if you look at an index fund, you will find that its beta is 1, and R-squared is closest to 1 if not 1.

• Upside Capture

An upside capture ratio over 100 indicates a fund has outperformed the benchmark during periods of positive returns for the benchmark. 

For example, If the Fund’s F 10-year upside capture ratio is 102, it has performed better than the benchmark by 2% over this period.

It is calculated by taking the fund’s upside capture return and dividing it by the benchmark’s upside capture return.

• Downside Capture

The value of a downside capture ratio less than 100 signals that a fund has lost less than its benchmark during periods when the benchmark has been in the red. 

For example, If the Fund’s F 10-year downside capture ratio is 88, it has captured 88% of the downside and protected the portfolio by 12% when the benchmark fell.

The ratio is calculated by dividing the fund’s returns by the index's returns during the down market and multiplying the result by 100.

• Tracking Error 

Tracking error measures the level of consistency or divergence between the performance of a passive mutual fund (Index fund or ETF) and its target Index. Mathematically, it is calculated as the annualised standard deviation of the return difference between the passive fund and its underlying Index.

Tracking error is usually expressed as a percentage that indicates the variability of the fund's performance relative to the index over a specific time period (1-month, 3-month, 1-year, 3-year, 5-year, etc.).

A higher tracking error suggests that the passive fund has deviated more from its benchmark, resulting in a greater difference in performance. It indicates that the fund's returns are less predictable and may vary significantly from the performance of the benchmark that it "tracks".

Tracking errors can arise due to factors such as the fund's expenses or how closely the fund manager can replicate the weights of the stocks in the Index in the passive fund’s portfolio.

Thus, a fund with lower tracking error is more desirable. However, it's important to note that tracking error alone does not determine the overall quality of a passive mutual fund.

• Information ratio

The Information ratio measures how much a fund outperforms its benchmark while considering the risk involved in achieving those higher returns. It is calculated by deducting the index's return from the portfolio's return and dividing it by the tracking error (in information ratio, tracking error is used as a measure of risk).

Information ratio = (Rp - Rb) / TE 

Where:

Rp = Mean return of the portfolio

Rb = Mean return of the benchmark 

TE = Tracking error 

A positive information ratio indicates that the fund was able to generate better returns than the benchmark. When comparing two or more funds using an information ratio, a higher information ratio indicates that a manager has consistently generated better returns than the benchmark index after adjusting for risks.

Summary

You cannot base your decision to invest in a fund just on one risk parameter. Each risk measure tells something about the fund. Each data should be compared with the same category of funds during a similar time period.