Gauging downside risk in mutual funds

Sortino ratio scores over Sharpe ratio as it factors in only the downside deviation

While choosing from among mutual funds, most retail investors often look for funds delivering higher returns. But they seldom look at the risk involved in the investment.

There are many statistical tools, such as standard deviation (SD), Sharpe ratio, beta, alpha and Sortino ratio that are used to measure the risk involved and risk-adjusted return generated by mutual funds.

Measuring risk

The risk of investment in mutual fund is the volatility or fall in net asset value (NAV) of the mutual fund. Standard deviation (SD) is the most commonly used tool measuring the volatility of the fund’s returns in relation to its average return.

While calculating the SD for a fund using the NAVs of the last one year for instance, you have to first calculate the daily returns. This will leave you with around 250 data points (taking only working days). Now calculate the average return. Then find out the excess return over the average return for each data point and then square them.

Dividing the summation of squared values by the total number of data points will give you the ‘variance’. Finally, the standard deviation is arrived at by calculating the square root of the variance.

SD is an efficient tool to gauge the risk involved in a fund, which could be compared with other funds in a category. A fund with lower standard deviation is a preferred investment option.

Risk-adjusted returns

Statistical ratios such as Sharpe ratio and Sortino ratio measure the ‘risk-adjusted returns’ in mutual funds.

The term risk-adjusted return defines the return the fund generated for the risk it took. It helps to assess the appropriate risk-return trade-off for the different risk profiles of investors. This is the way most portfolio managers and robo advisories tailor mutual fund portfolios for the various types of their investors.

Sharpe ratio measures how much extra return a fund has generated over the risk-free rate per unit of risk. While calculating the Sharpe ratio, the risk-free rate is subtracted from the fund return and then divided by the standard deviation ((fund return – risk-free rate)/SD).

Here, the yields of 91-day T-bill is taken as risk-free rate. Sharpe ratio is a widely accepted measure representing the trade-off between risk and returns.

Here it is to be noted that the SD, which is used in the calculation of Sharpe ratio, portrays how widely the fund’s returns as a whole varied from its average returns. But the SD includes both the upside deviation and downside deviation.

However, upside deviation is not at all a risk component.

Here, the Sortino ratio comes into the picture. It scores over the Sharpe ratio as it factors in only the downside deviation. For this, the Sortino ratio uses the downside standard deviation in its calculation instead of the standard deviation that is used in calculating the Sharpe ratio.

The calculation for the downside standard deviation (or semi-standard deviation) is similar to that of the normal standard deviation but it takes into account only the negative returns over the average return.

Commonly, the Sharpe ratio is preferred to evaluate low-volatility investment products while the Sortino ratio is used to evaluate high-volatility products.

A higher Sortino ratio indicates low probability of a large loss. For instance, two funds from the large-cap category — Aditya Birla SL Advantage Fund and HDFC Top 200 Fund — generate almost similar rolling returns of 14 per cent over a three-year time-frame.

But their three-year daily Sortino ratio works out to 0.08 and 0.04 per cent, respectively. Considering the higher Sortino ratio, Aditya Birla SL Advantage Fund is the preferable option for investment between the two.

All the three ratios are readily available in mutual fund factsheets and online resources such as Value Research online and Morningstar.

Considering only statistical ratios while selecting funds may not be a good idea. Coupled with parameters such as consistency, diversification and expense ratio, choosing funds based on statistical indicators may help.

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