Adjusting risk And returns

As the markets continue to shoot upwards, returns for the investor are getting better by the day. Most fund managers are also scrambling to outperform each other. But as an investor though aspiring for returns may be great, you should also be constantly looking at the risks that are attached with your mutual fund investments.

All of us know that risk and returns are related. Higher returns are always accompanied by higher levels of risk. And when the going is good, this fact is mostly ignored. However, a sharp correction exposes such funds immediately resulting in huge losses for investors. It is important to understand the concept of risk-adjusted returns and how to calculate it. Let us look at total returns first. Total gains on your investment is simply the difference between the present net asset value (NAV) vis-a-vis over the NAV at which you entered the fund. Also, if you have gone for the dividend option, then you need to add those returns to gauge the total gains.

Divide the total gains by the initial NAV and multiply the result by 100, we get our total returns in percentage format (Total gains/initial NAV*100). Further, to annualise the returns, multiply the result by the number of days you were invested and divide it by 365 days. However, these are simple total returns, without any adjustment for the risk involved.

To calculate risk-adjusted returns, let us look at some basic concepts.

Standard deviation: It is the degree of volatility that a portfolio goes through in the short-term. It measures the extent to which this fluctuation in NAV occurs in comparison to the average returns of the fund during any period of time.

Beta: This measure determines the volatility or risk of a fund in comparison to the benchmark index. Beta measures the systematic risk and returns of a fund. For instance, if the beta of a stock or a fund is 1.5, then it will increase by Rs 1.5 for every Re 1 rise in the benchmark index and vice versa.

Alpha: This is the unsystematic risk which is peculiar to a certain fund and can be removed by diversification and proper securities selection by the fund manager. The returns that a fund generates over and above its expected returns, is called 'alpha' returns.

Armed with these various definitions, let us look at the basic concept of risk-adjusted returns. For a fund, the investor has to be compensated on two fronts. One, for the time for which he stays invested, and the other, for the risk he takes by investing in that fund. The former is taken care of by providing him with risk-free returns by investing in government securities. The latter is compensated by investing in equities. And here, the returns are higher, but so are risks.

Since the 1960s, several authors have worked to find a proper system of measuring risk-adjusted returns. Though there are many such theories, we will briefly discuss two models, the Sharpe Ratio and the Fama Ratio.

Sharpe Ratio: Conceptualised by William Sharpe, it is a ratio of returns generated by the fund over and above risk-free rate of return. According to Sharpe, investors are concerned with the total risk of the fund. And while a positive and high Sharpe Ratio shows superior risk-adjusted performance of a fund, a negative or low Sharpe Ratio is an indication of inferior performance.

Fama Ratio: The Eugene Fama model compares the returns given by a fund with the required returns commensurate with the risk associated with it. The difference between the actual and required return is considered as a measure of the performance of the fund and called 'Net Selectivity', which represents the fund manager's stock selection skills. A high value indicates that the fund manager has performed and earned above the return commensurate with the level of risk taken by him. Greater the difference, better is the fund's performance.

Though, these ratios and formulas sound complex to the potential investor, it is very important for to look at them as they reflect the ability of the fund to perform over time.

The writer is, director Touchstone Wealth Planners