Investors are concerned with the maximisation of the returns that they actually earn from their mutual fund investments. They are constantly in search of those funds that give them higher return and for this purpose they look at various parameters like the past performance over different time periods, the composition of the portfolio and so on. This is one way of going about the entire investment process but there is one element that is not being addressed here properly and that is the element of risk.

Investors know that there is a clear relationship present between the risk and the return that is generated from an investment. What this means is that investors will be willing to take a higher risk if they want a higher return to come to them like an equity investment where the returns can potentially be high but at the same time there could also be a loss of capital if things do not work out well.

This kind of analysis is simple but it is useful in the real world only when this a matter of selection between an equity scheme and a debt scheme or two funds where there is a large difference in the manner of their investments in different asset classes  such that the difference can be witnessed easily. In reality this is not always possible, especially when the investor has to choose between a variety of funds that are of a similar asset class, have a similar investment, and hence they need to look at something more than just the pure returns.

Risk adjusted returns

There is a need for investors to look at the concept of risk adjusted returns as this will give them a better picture of the whole situation. The problem with looking at only absolute returns in making comparisons is the fact that this does not focus on any other feature within the entire calculation. This means that the investor has no idea about the risk that the fund has taken in the process of earning a certain amount of return. This could lead to situations where a fund rises significantly during a bull run but then falls as sharply leaving the investor with little in their hands to show for their investments. The risk adjusted return working seems to tackle this problem as it considers the risk that has been taken to earn a certain amount of return and hence the investor will get a better picture of the whole situation. This will enable them to ensure that they are able to make the right choice while they are selecting a particular fund.

Sharpe Ratio

There are different ways in which the investor can view the risk adjusted returns of the fund as there are a lot of ratios that can show this picture; however, one measure that is quite commonly used is the Sharpe Ratio. This is a ratio that will enable the investors to make the right choice in the entire matter. First a look at the manner in which this ratio is calculated will give a better idea to the user about what it seeks to do. This ratio involves deduction of the risk free rate of return from the return of the fund and the resultant figure is divided by the standard deviation of the fund.

If we take a careful look at the manner in which the ratio is calculated, then this will show that what it shows is how much more a particular fund has been able to earn over the risk free rate. Further, this extra earning is compared to the volatility faced in actual terms by using the standard deviation to arrive at the final figure of the ratio. Take for example a situation where a fund has a return of 14 per cent while the risk free rate is 7 per cent and another fund that has a return of 18 per cent. If the standard deviation of the first fund is 5 and the standard deviation of the second fund is 9, then the Sharpe Ratio will present the actual picture in a better manner.

If the traditional route of looking at the absolute returns is adopted, then it is witnessed that the second fund will be considered a better fund as the returns in absolute terms is higher here. However, let us see what happens when the Sharpe Ratio is considered. Now the working will show that the ratio for the first fund is 1.4 while the ratio for the second fund is 1.22. Now a higher Sharpe Ratio means a better performance for the fund on a risk adjusted basis so the first fund is actually better in terms of the risk return analysis while a cursory look might make the second fund look better.

Actual figures

For an investor it is not important to know the working of the calculation of the ratio as they are not going to sit and do the calculation for the various funds that are available for investment. So what is actually important for them is to know the way in which they should be interpreting the figures that are in front of them as this will help them in their decision making process. These figures are available from various sources like the fund house itself or there are research agencies which calculate and then put out these figures. There is one big point that the investor has to keep in mind when they are considering the details here. This is that they should not make the mistake of just taking different figures from different sources and then make a decision. This happens because one might not know the details that have been used in the working out the various calculations; so it could be that the investor is not comparing the right figures. This is the reason why it is necessary that the same figures for the risk free rate is used and that the standard deviation calculations are uniformly done so that the final figures are also comparable for the investor.

Nature of returns

As it can be seen that there could be cases where a higher return might not be good from the risk return angle and hence this could actually be a slightly worse investment when the risk is factored into the investment. At the same time, the investor also has to look at the nature of the figures that are given out by these calculations. Just because a figure for a fund is slightly more does not necessarily mean that it is a better fund in risk return terms. For example, in several cases there is a very small difference that is witnessed between various funds so there could be one scheme at a ratio of 1.27 and the other at 1.23. In many such cases the investor might need to look at several other factors while they are making the decision as it will help in a balanced outlook rather than going by just a single factor that might not give the right picture.

Past and decision making

Another thing that the investor also has to note is that the figures that are available for the ratios used for looking at risk return analysis are based on the past performance and there is no guarantee that a similar one will be witnessed in the future. What this means is that there could be a change in the situation in the coming days which will impact the investment and one must be prepared for such changes. When it comes to the actual decision making, the investor can follow a certain procedure. They can consider the manner in which the fund has been performing and then look at the risk return matrix to ensure that the fund does not take a risk that is higher than what the investor can bear. This will ensure that the final decision is appropriate and suitable for their requirements.
(The writer is Chief Coach at FinCare Consulting)