Last Updated on September 4, 2018 at 10:19 am
Nearly two years ago, one of my personal finance influencers, Ramesh Mangal, cautioned me that there is no clear-cut relationship between risk and reward. Although he had pointed me towards proof of the same, I did not pay much heed to it at that time.
Now after being reasonably comfortable with commonly used risk-return metrics like alpha, beta, Sharpe ratio, Sortino ratio etc. I am beginning to understand what he meant.
In a previous post, I had compiled risk and returns data from Value Research Online and presented the standard deviation and 3-year returns.
In this post, I will present other risk and return metrics for equity mutual funds from the same data set. Hopefully, it will help us understand the interrelationships among risk, return and volatility.
Join 32,000+ readers and get free money management solutions delivered to your inbox! Subscribe to get posts via email! (Link takes you to our email sign-up form)
🔥Enjoy massive discounts on our robo-advisory tool & courses! 🔥
Note: If you would like to understand more about risk and return metrics, here is a non-technical writeup.
If you want to evaluate mutual funds with different risk/return metrics, use the Mutual Fund Risk and Return Analyzer
Reward vs. Risk
Let us assign the standard deviation (measure of deviation from the average return) as risk and alpha – the risk-adjusted measure of excess returns above the benchmark as reward.
We will assume alpha is calculated over a 3 year period. Value Research online does not specify the time period. For equity mutual funds it could be anywhere between 3-5 years.
Here is how alpha vs. standard deviation for all equity mutual funds (balanced, diversified, sector) looks.
- Most funds (84%) have an alpha above zero. That is, they have beat the benchmark over a 3 year period. Not music to the ears of those who believe in index investing.
- The average alpha is about 3%. There are many (46%) ‘above-average’ funds!
- There is a bunching of funds around a standard deviation of 18 (corresponding to most diversified equity funds) but there are a good number of points on either side of this bunch.
- If we choose a diversified equity fund and hold on it for 3Y, there is a good chance of beating the market (so stay calm!).
- A ‘good’ diversified mutual fund is just about any fund within the blue rectangle. That is within one standard deviation from the average standard deviation of all equity funds (sorry that sounds weird!)
- Having lone sector funds in the folio is not a smart idea because not only are they risky (high standard deviation > 25) but also come with high uncertainty wrt beating the index.
- Many funds manage to beat the market, on either side of the boxed region.
- Within the box, there is a high probability of getting a positive alpha. For lower or higher standard deviations, alpha could be positive or negative!
Therefore,
- Overall there is poor correlation between reward and risk. Higher risk does not imply higher reward.
- A ‘typical’ diversified mutual fund has a decent change of beating the market, provided we let it, by staying invested!
Reward vs. Volatility
Beta is a measure of fund volatility relative to its benchmark. A fund with beta less than 1, is less volatile than its benchmark. A fund with beta equal to 1 is as volatile and as its benchmark.
Here is a plot of alpha versus beta. That is reward versus volatility.
- The points are heaped around beta =1 with many funds between beta = 0.8 to 1.
- So most of the funds that have beat the benchmark are either as volatile as the benchmark (over a 3y period) or just a little less volatile.
- Only 28% of funds with beta greater than or equal to 1 have beat the benchmark.
- Therefore, downside protection (Beta <1) is important but is not a guarantee of positive alpha. Only 57% of funds with beta < 1 have generated a positive alpha (beat the benchmark)
Reward vs. Correlation
R-squared is the percentage of funds movement linked to the benchmarks movement. An index fund will have an R-squared =1 (100%, the max. value).
Here is a plot of alpha vs. R-squared
- Notice the bunching about R-squared = 0.9.
- Funds with highest (or lowest) alpha are not well correlated with the benchmark!
- Most funds are well correlated with their benchmarks and yet manage to produce a small alpha.
- A good 65% of funds with R-squared greater than 0.8 have beaten the benchmark. Thus having funds with a strong overlap with the benchmark is not a ‘bad’ thing at all!
- I would like to think that this implies that their portfolio have the same stocks as the benchmark but in different proportions.
- This also supports the inference made in an earlier post that fund selection is not as not important as it is made out to be. What matters is investor-persistence. Any old diversified fund with reasonably strong correlation with the benchmark is likely to do the job.
- Choosing a fund with low R-squared is a risk as the alpha could be negative.
Conclusions
- There is no relationship between risk and reward. Higher risk does not imply higher reward.
- Funds more volatile than their benchmarks have trouble beating their benchmarks
- There is a decent chance of a fund beating its benchmark, if it is less volatile or even as volatile as the benchmark.
- Nav movement of most funds that have beaten their benchmark are typically more than 80% correlated with their benchmark. Thus, even if over short periods of time, the fund does not beat the benchmark, if you stick with it, you are likely to reap rewards.
🔥Enjoy massive discounts on our courses, robo-advisory tool and exclusive investor circle! 🔥& join our community of 7000+ users!
Use our Robo-advisory Tool for a start-to-finish financial plan! ⇐ More than 2,500 investors and advisors use this!
Track your mutual funds and stock investments with this Google Sheet!
We also publish monthly equity mutual funds, debt and hybrid mutual funds, index funds and ETF screeners and momentum, low-volatility stock screeners.
- Do you have a comment about the above article? Reach out to us on Twitter: @freefincal or @pattufreefincal
- Have a question? Subscribe to our newsletter using the form below.
- Hit 'reply' to any email from us! We do not offer personalized investment advice. We can write a detailed article without mentioning your name if you have a generic question.
Join 32,000+ readers and get free money management solutions delivered to your inbox! Subscribe to get posts via email! (Link takes you to our email sign-up form)
About The Author
Dr 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 ten years of experience publishing news analysis, research and financial product development. Connect with him via Twitter(X), 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 promoting unbiased, commission-free investment advice.Our flagship course! Learn to manage your portfolio like a pro to achieve your goals regardless of market conditions! ⇐ More than 3,000 investors and advisors are part of our exclusive community! Get clarity on how to plan for your goals and achieve the necessary corpus no matter the market condition is!! Watch the first lecture for free! One-time payment! No recurring fees! Life-long access to videos! Reduce fear, uncertainty and doubt while investing! Learn how to plan for your goals before and after retirement with confidence.
Our new course! Increase your income by getting people to pay for your skills! ⇐ More than 700 salaried employees, entrepreneurs and financial advisors are part of our exclusive community! Learn how to get people to pay for your skills! Whether you are a professional or small business owner who wants more clients via online visibility or a salaried person wanting a side income or passive income, we will show you how to achieve this by showcasing your skills and building a community that trusts and pays you! (watch 1st lecture for free). One-time payment! No recurring fees! Life-long access to videos!
Our new book for kids: “Chinchu Gets a Superpower!” is now available!
Must-read book even for adults! This is something that every parent should teach their kids right from their young age. The importance of money management and decision making based on their wants and needs. Very nicely written in simple terms. - Arun.Buy the book: Chinchu gets a superpower for your child!
How to profit from content writing: Our new ebook is for those interested in getting side income via content writing. It is available at a 50% discount for Rs. 500 only!
Do you want to check if the market is overvalued or undervalued? Use our market valuation tool (it will work with any index!), or get the Tactical Buy/Sell timing tool!
We publish monthly mutual fund screeners and momentum, low-volatility stock screeners.
About freefincal & its content policy. Freefincal is a News Media Organization dedicated to providing original analysis, reports, reviews and insights on mutual funds, stocks, investing, retirement and personal finance developments. We do so without conflict of interest and bias. Follow us on Google News. Freefincal serves more than three million readers a year (5 million page views) with articles based only on factual information and detailed analysis by its authors. All statements made will be verified with credible and knowledgeable sources before publication. Freefincal does not publish paid articles, promotions, PR, satire or opinions without data. All opinions will be inferences backed by verifiable, reproducible evidence/data. Contact information: letters {at} freefincal {dot} com (sponsored posts or paid collaborations will not be entertained)
Connect with us on social media
- Twitter @freefincal
- Subscribe to our YouTube Videos
- Posts feed via Feedburner.
Our publications
You Can Be Rich Too with Goal-Based Investing
Published by CNBC TV18, this book is meant to help you ask the right questions and seek the correct answers, and since it comes with nine online calculators, you can also create custom solutions for your lifestyle! Get it now.Gamechanger: Forget Startups, Join Corporate & Still Live the Rich Life You Want
This book is meant for young earners to get their basics right from day one! It will also help you travel to exotic places at a low cost! Get it or gift it to a young earner.Your Ultimate Guide to Travel
This is an in-depth dive into vacation planning, finding cheap flights, budget accommodation, what to do when travelling, and how travelling slowly is better financially and psychologically, with links to the web pages and hand-holding at every step. Get the pdf for Rs 300 (instant download)