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

Published: June 22, 2022 at 6:00 am

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.

Join over 32,000 readers and get free money management solutions delivered to your inbox! Subscribe to get posts via email!
🔥Enjoy massive discounts on our robo-advisory tool & courses! 🔥
  • 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)
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.

CategoryRating based on return difference
Arbitrage Fundlow risk
Liquidlow risk
Overnight Fundlow risk
Money Marketlow risk
Floating Ratelow risk
Ultra Short Durationlow risk
Banking and PSU Fundlow risk
Corporate Bondlow risk
Short & Mid Termlow risk
Debtlow risk
Gilt Fund with a 10-year constant durationlow risk
Medium to Long Durationlow risk
Long Durationlow risk
Low Durationmedium risk
Dynamic Bondmedium risk
Short Durationmedium risk
Equity Savingsmedium risk
Conservative Hybrid Fundmedium risk
Debt Orientedmedium risk
Medium Durationmedium risk
Dynamic Asset Allocationmedium risk
Balanced Advantagemedium risk
Multi Asset Allocationmedium risk
Solution Oriented – Children’s Fundmedium risk
MNCmedium risk
Solution Oriented – Retirement Fundmedium risk
Aggressive Hybrid Fundmedium risk
Pharma & Health Caremedium risk
Globalmedium risk
ConsumptionHigh Risk
Equity OrientedHigh Risk
Large Cap FundHigh Risk
Dividend YieldHigh Risk
Index – Nifty Next 50High Risk
Index Funds – OtherHigh Risk
Flexi Cap FundHigh Risk
Index – SensexHigh Risk
Thematic FundHigh Risk
Mid Cap FundHigh Risk
Equity Linked Savings SchemeHigh Risk
GoldHigh Risk
Index – NiftyHigh Risk
Focused FundHigh Risk
ContraHigh Risk
Service IndustryHigh Risk
Large & Mid CapHigh Risk
Energy & PowerHigh Risk
Multi Cap FundHigh Risk
ETFs – OtherHigh Risk
TechnologyHigh Risk
InfrastructureHigh Risk
Value FundHigh Risk
FoFs (Overseas)Very High Risk
Small cap FundVery High Risk
IndexVery High Risk
Banks & Financial ServicesVery High Risk
AutoVery High Risk
Credit Risk FundVery 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.

Do share this article with your friends using the buttons below.

🔥Enjoy massive discounts on our courses, robo-advisory tool and exclusive investor circle! 🔥& join our community of 5000+ users!
Use our Robo-advisory Tool for a start-to-finish financial plan! More than 1,000 investors and advisors use this!
New Tool! => 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.
Follow Freefincal on Google News
Follow Freefincal on Google News
Subscribe to the freefincal Youtube Channel. Subscribe button courtesy: Vecteezy.
Subscribe to the freefincal Youtube Channel.
Follow freefincal on WhatsApp Channel
Follow freefincal on WhatsApp
Podcast: Let's Get RICH With PATTU! Every single Indian CAN grow their wealth! 
Listen to the Lets Get Rich with Pattu Podcast
Listen to the Let's Get Rich with Pattu Podcast
You can watch podcast episodes on the OfSpin Media Friends YouTube Channel.
Lets Get RICH With PATTU podcast on YouTube
Let's Get RICH With PATTU podcast on YouTube.
🔥Now Watch Let's Get Rich With Pattu தமிழில் (in Tamil)! 🔥
  • 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 over 32,000 readers and get free money management solutions delivered to your inbox! Subscribe to get posts via email!

About The Author

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 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!
Both boy and girl version covers of Chinchu gets a superpower
Both the boy and girl-version covers of "Chinchu Gets a superpower".
Most investor problems can be traced to a lack of informed decision-making. We made bad decisions and money mistakes when we started earning and spent years undoing these mistakes. Why should our children go through the same pain? What is this book about? As parents, what would it be if we had to groom one ability in our children that is key not only to money management and investing but to any aspect of life? My answer: Sound Decision Making. So, in this book, we meet Chinchu, who is about to turn 10. What he wants for his birthday and how his parents plan for it, as well as teaching him several key ideas of decision-making and money management, is the narrative. What readers say!
Feedback from a young reader after reading Chinchu gets a Superpower (small version)
Feedback from a young reader after reading Chinchu gets a Superpower!
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
Our publications

You Can Be Rich Too with Goal-Based Investing

You can be rich too with goal based investingPublished 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 Gamechanger: Forget Start-ups, Join Corporate and Still Live the Rich Life you wantThis 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

Travel-Training-Kit-Cover-new 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)