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Can we use returns to classify mutual funds in terms of risk?

Mutual fund NAV risk is measured using the standard deviation. This can be thought of as the average deviation of a monthly return from the average monthly return. Higher the value, the higher the risk. Unfortunately, this is not an intuitive number like the return. So this begs the question, is it possible to classify mutual fund risk using their returns?

Let us consider L&T Overnight Fund. Over the last 3Y (as of 6th June 2022) its annualized return is 3.435% (this is the CAGR). Over this 3Y period, the average monthly return is 0.282%.

Now we annualize this monthly return: = (1+0.282%)^12-1 = 3.437%. Notice that there is practically no difference between the CAGR and the annualized monthly return. Ideally, in the case of a fixed-income instrument with no market volatility, the CAGR and the annualized monthly return will be identical.

As the market volatility increases, the difference between the two quantities also increases. This is a direct return-based volatility measure.

Now consider IDBI Hybrid Equity  Fund.

  • 3Y CAGR: 9.339%
  • Annualised monthly returns: 10.863%.
  • Difference: 1.52%. Notice the significant increase in the difference.

This difference is a return-based measure of mutual fund volatility. This data is readily available in mutual fund rating portals. For example, on any Value Research fund page, the 3Y return is available in the “Peer Comparison” comparison table. The annualized average monthly return is available in the “Risk Measures (%)” table.

The graph below shows the difference between annualised average monthly return and 3Y annualized return (y-axis) vs Standard deviation (x-axis) for 874 mutual funds.

Difference between annualised average monthly return and 3Y annualized return (y-axis) vs Standard deviation (x-axis)

The straight line is the standard deviation reference line. The return difference is rather subdued than the standard deviation for low values and quickly picks up. This means that the return difference is not a good measure to differentiate a money market fund from an overnight fund. It will work better when comparing an equity fund with a debt fund.

For a detailed classification of risk based on standard deviation see: How can I tell if a mutual fund is less/more risky than other funds?

It must be understood that both the standard deviation and return difference are measures of volatility. They are not indicators of the underlying cause of the volatility! They cannot measure the latent risk that does not manifest in the fund’s NAV. In other words, volatility is realised risk. There are many other unrealised factors which cannot be quantified via the NAV. See: Basics: What is the difference between risk and volatility?

A risk scale based on annualised monthly return minus CAGR

  1. Get the 3Y CAGR and annualised monthly returns of 874 funds over the last 3Y across 58 scheme classifications (some thematic funds are individually classified, hence the large number).
  2. Compute, return difference = annualized monthly return minus 3Y CAGR
  3. Find the min and max return difference of each category
  4. Find the simple average of this min and max.
  5. So now we have a table of categories and avg. return differences
  6. Find the average (m) and standard deviation (s) of the above set
  7. Funds that lie above m+s we classify as very high risk
  8. Funds that lie between m and m+s we classify as high risk
  9. Funds that lie between m-s and m we classify as medium risk
  10. Funds that lie below m-s we classify as low risk

This is a pictorial representation of the classification. As mentioned above, the low-risk classification is not accurate. Some of the category placements are non-intuitive.

A risk scale based on annualised monthly return minus CAGR
A risk scale based on annualised monthly return minus CAGR

These are the scheme-wise ratings.

Category Rating based on return difference
Arbitrage Fund low risk
Liquid low risk
Overnight Fund low risk
Money Market low risk
Floating Rate low risk
Ultra Short Duration low risk
Banking and PSU Fund low risk
Corporate Bond low risk
Short & Mid Term low risk
Debt low risk
Gilt Fund with a 10-year constant duration low risk
Medium to Long Duration low risk
Long Duration low risk
Low Duration medium risk
Dynamic Bond medium risk
Short Duration medium risk
Equity Savings medium risk
Conservative Hybrid Fund medium risk
Debt Oriented medium risk
Medium Duration medium risk
Dynamic Asset Allocation medium risk
Balanced Advantage medium risk
Multi Asset Allocation medium risk
Solution Oriented – Children’s Fund medium risk
MNC medium risk
Solution Oriented – Retirement Fund medium risk
Aggressive Hybrid Fund medium risk
Pharma & Health Care medium risk
Global medium risk
Consumption High Risk
Equity Oriented High Risk
Large Cap Fund High Risk
Dividend Yield High Risk
Index – Nifty Next 50 High Risk
Index Funds – Other High Risk
Flexi Cap Fund High Risk
Index – Sensex High Risk
Thematic Fund High Risk
Mid Cap Fund High Risk
Equity Linked Savings Scheme High Risk
Gold High Risk
Index – Nifty High Risk
Focused Fund High Risk
Contra High Risk
Service Industry High Risk
Large & Mid Cap High Risk
Energy & Power High Risk
Multi Cap Fund High Risk
ETFs – Other High Risk
Technology High Risk
Infrastructure High Risk
Value Fund High Risk
FoFs (Overseas) Very High Risk
Small cap Fund Very High Risk
Index Very High Risk
Banks & Financial Services Very High Risk
Auto Very High Risk
Credit Risk Fund Very High Risk

In summary, while in principle mutual fund volatility can be measured in terms of “annualized monthly return minus CAGR” it is not as sensitive as the standard deviation for short-term debt mutual funds. It can however be used as a crude measure by investors to appreciate how volatile an equity fund or a hybrid fund is.

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Pattabiraman editor freefincalDr M. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. He has over nine years of experience publishing news analysis, research and financial product development. Connect with him via Twitter or Linkedin or YouTube. Pattabiraman has co-authored three print books: (1) You can be rich too with goal-based investing (CNBC TV18) for DIY investors. (2) Gamechanger for young earners. (3) Chinchu Gets a Superpower! for kids. He has also written seven other free e-books on various money management topics. He is a patron and co-founder of “Fee-only India,” an organisation for promoting unbiased, commission-free investment advice.

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