Mutual Fund Investments are Subject to market risk.

Recently I saw an advertisement about Mutual Funds. As a CFA candidate, I found them funny. Well, you will also think same if you understand the language.

I don’t have objection for making an advertisement for Mutual funds. But the way this advertisement makes it,i dont know what to say. Then there is this one sentence

I don’t even remember how many times I saw jokes about it.

It makes me to write this blog post.

Mutual Funds are very useful way to invest. But the way many people even AMFI, The association of Asset Management in India, is doing it all wrong. I don’t found anything about risk in all such advertisement. Why I am telling about it? Every children in India knows that “Mutual Funds Investments are subject to market risk.” But no one knows what does it mean.

So, How to analyse risk of Mutual Funds and how to asses expected return?

R Squared : How much the data is useful and faithful

R square or Coefficient of determination is very important measure in analyzing future performance of stock, ETF or even mutual fund. In simple word, it is telling you if the data is faithful and how much.

In more simple word, you maybe aware about term Beta. If you are not, don’t worry. Its one of the five risk measure we are going to check in this post. What Beta is telling you that if Benchmark , which is generally index like S&P 500, Sensex, Nifty,  move 1% in one direction then how much security will move.

Now, there is no superfine calculations to do that. Lets say security X having Beta 1.5. Index moved 7 unit. as per calculation security is supposed to move 10.5 unit. But it may or may not be true. it may increase by 10, 9, 4 or even decrease also. R squared is trying to tell you how much percentage possibility is that future data will follow the correlation that is beta in simple language.

Image is clearly showing that right image is better to predict future, whereas if you want to try with left image, its difficult.

Generally, it is shown like 0.18 or 0.60 or in percentage format Like 18% 60%. Its always between 0 and 1 or les than 100% Rule of thumb in R Square or Coefficient of determination is higher the better. As per Morningstar above 85% is good.

 

Beta : Volatility

Beta is systematic risk investor is facing for holding of security or Portfolio like Mutual Fund or ETF and not market as whole. That is what definition is telling you. Ignore it. Take it in this way.

Lets say you are holding SBI, State Bank of India. The stock is part of both large cap equity indices in India, S&P BSE Sensex and NIFTY. so when you are buying only stock of SBI, you are not buying another 50 stocks in nifty and 29 stocks in sensex. so its better to take it that price movement of SBI maybe different then SENSEX. which it is. lets say that 1.8 . That means when sensex will go up for 1%, SBI will move up in 1.8%. But its not necessary. so how much its predictable? There comes R squared. If R squared is above 85% its very good . less than 85% but above 60%, still good. Many will say near the 60%, bad it is.

Beta itself will give you some good information about risk and return. Lets say that if sensex is giving you 12% return. so with 1.8 beta, SBI is supposed to give you 21.8% return. That is why because you are investing in specific stock and taking specific risk of that business. As its long term beta on SBI its expected return on  stock LONG TERM.

One more thing about beta and I am done with beta. YES you can calculate Daily beta but they are useless.

Alpha : Measure of return on risk adjusted basis

Tracking error in index fund is nothing but Alpha.

What is alpha? excess return made on portfolio, with risk adjusted profile.

More simple word. say Sensex made 12% SBI made 24%. So alpha is12%. Now you can understand what is Tracking error and why they takes place. there is some mechanism which change the index funds as the portfolio is changed. say there is new addition of Kotak bank in sensex. Now in theory there is no cost. So even if there is change, index will not different. But in real life, there are cost of buying stocks and selling stocks. so when the MECHANISM will do that, there is some difference. Either its better or worse than index. If you are investing in Active management fund and having negative alpha, why you are even investing? buy ETF. That’s it.

Standard Deviation : How much final result can deviate

Standard deviation is measure of dispersion from its mean. Its square root of variance by determine variation between each data point relative to the mean.

Once again, ignore it.

what is this telling you is say you expect 15% return on investment. But its not sure that you will get same. How much return you will get? what are possibilities?

There will be range, in which you will get return. Say 10%-20%. How to determine it? what history says about it. say historically one Mutual fund is having deviation 2%. another is 5%. here 5% is more risky and that’s why you may received more and better return potentially.

Sharpe Ratio : Measure of risk adjusted return

In simple words sharpe Ratio is telling you what you will earn by taking 1 unit of risk.

Now in simple word. there is something called Risk Free Rate. There is just no or negligible risk on such investments. best example is Govt securities. Like treasury securities in US, Govt 10 year bonds in India. simple reason is Govt cant default and such securities are sufficient liquid means you can sell them at any time. They will give you sufficient return to outperform inflation. But that is not sufficient when it comes to generating wealth. You supposed to make something more. But the question is at what cost? by taking how much risk? there are many ways to calculate risk like beta, standard deviation etc. I dont want to go into more difficult terminology.

Going to end it with tweet.

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About Ashutosh Tilak

Tracking Indian Capital Market since 2010. Finance Student, On this blog I am writing about finance and Investing. You can contact me analystashu@gmail.com or @androidashu & @InsideFinanc on twitter