Risk, return and performance of funds

Return is what the client asks about; risk is what the client experiences. A distributor who can measure both can explain why a 14% fund with wild swings may suit the client less than an 11% fund that lets them sleep. The exam asks for formulas and for the names of the measures, with at least one CAGR or duration calculation.

Measuring return

Absolute return is the plain percentage change: a NAV moving from ₹20 to ₹26 is a 30% absolute return, regardless of how long it took. It is the right measure for periods under one year. Simple annualised return scales an absolute return linearly to a year (30% in 18 months is 20% simple annualised), which ignores compounding and is used only for very short periods such as 7, 15 and 30 days in liquid funds. For periods above one year, SEBI requires the compound annual growth rate.

Where cash flows happen on different dates, as in a SIP or a portfolio with purchases and redemptions, a single CAGR does not exist. The correct measure is the XIRR (extended internal rate of return), the single rate that discounts every cash flow to the present and makes them sum to zero. Factsheets and CAS statements show XIRR for SIPs. When a scheme has paid IDCW, the return should be computed on the assumption that the payout was reinvested at the ex-IDCW NAV, otherwise the growth in NAV understates what the investor earned.

Risks inside an equity fund

Equity funds face market risk (the whole market falls), company-specific risk (one holding disappoints, reduced by diversification), sector and thematic risk (concentrated funds swing with their sector), liquidity risk (small cap stocks are hard to sell in size without moving the price), and concentration risk (a focused fund with 25 stocks moves more than a 60-stock diversified fund). The measures:

• Standard deviation measures total volatility of returns around the average. A fund with a standard deviation of 18% swings more than one at 12%. It captures all risk, systematic and unsystematic.
• Beta measures sensitivity to the market: a beta of 1.2 means the fund tends to move 12% when the benchmark moves 10%. Beta captures only market (systematic) risk. A beta below 1 is defensive.

As a rule, small cap schemes carry higher standard deviation than mid cap, which carry more than large cap; sectoral funds carry more than diversified funds.

Risks inside a debt fund

A debt fund's NAV moves for reasons most investors do not expect from "safe" products.

• Interest rate risk: bond prices and yields move in opposite directions. When market yields rise, existing bonds with lower coupons fall in price, and the NAV falls. The sensitivity is measured by duration. Macaulay duration is the weighted average time to receive the bond's cash flows, in years, and is what SEBI uses to define the debt categories. Modified duration converts that into price sensitivity: a modified duration of 4 means the NAV falls roughly 4% if yields rise by 1% (100 basis points), and rises 4% if yields fall by 1%. Longer maturity means higher duration means more interest rate risk.
• Credit risk: the issuer may default or be downgraded. Credit ratings (AAA down to D) signal the probability; a downgrade causes a markdown in the NAV even without default. SEBI allows a fund to create a segregated portfolio (side pocket) for a defaulted security so that redemptions in the main portfolio are not distorted.
• Liquidity risk: corporate bonds trade thinly, so selling in a stressed market means accepting a discount. SEBI requires liquid and other debt funds to hold minimum liquid assets.
• Reinvestment risk: coupons and maturities are reinvested at lower prevailing rates.

The factsheet reports yield to maturity (the portfolio's return if held to maturity with no defaults, before expenses), average maturity, Macaulay and modified duration, and the rating profile. A high YTM relative to peers in the same category is a warning sign of credit risk being taken.

Risk-adjusted return

Raw return without risk is half the picture. The standard measures:

• Sharpe ratio = (Fund return − Risk-free rate) ÷ Standard deviation. Excess return per unit of total risk. Higher is better, and it is the right comparison between funds of the same category. A fund returning 14% with 16% standard deviation and a risk-free rate of 6% has a Sharpe ratio of 0.50.
• Treynor ratio = (Fund return − Risk-free rate) ÷ Beta. Excess return per unit of market risk.
• Alpha (Jensen's) = Fund return − [Risk-free rate + Beta × (Benchmark return − Risk-free rate)]. The return the manager added beyond what the fund's market exposure explains.
• Sortino ratio uses only downside deviation in the denominator, penalising bad volatility, not good.
• Tracking error is the standard deviation of the difference between a fund's return and its benchmark's return; it is the key measure for index funds and ETFs.

Riskometer and the potential risk class matrix

The riskometer converts the portfolio into one of six labels: Low (risk value up to 1), Low to Moderate (1 to 2), Moderate (2 to 3), Moderately High (3 to 4), High (4 to 5) and Very High (above 5). Equity holdings score on market capitalisation, volatility and impact cost; debt holdings score on credit rating, interest rate (duration) and liquidity; the weighted average gives the scheme's risk value. It is recalculated monthly and disclosed within 10 days of month end, next to the benchmark's riskometer.

Debt schemes additionally display a potential risk class (PRC) matrix, which states the maximum risk the scheme may take. Credit risk is classed A (credit risk value 12 or more, essentially AAA and government paper), B (10 or more) or C (below 10). Interest rate risk is classed I (Macaulay duration up to 1 year), II (up to 3 years) or III (any duration). A scheme labelled A-I promises the lowest risk on both axes; C-III the highest. Unlike the riskometer, which reports the current portfolio, the PRC is a ceiling, and moving to a higher-risk cell is a change in fundamental attributes.