Last Updated on October 23, 2020 at 12:09 pm
Investors often wish to classify mutual funds beyond the SEBI designated categories. A natural way to do this is to try and classify them in term of returns: high-return funds, medium-return funds and low-return funds. With low, medium and high defined in terms of say, an SBI fixed deposit account. Will this work?
Immediately a classification based on returns will run into difficulties. Take a Nifty index fund and find out its returns. Over what duration is the obvious question. Over a three year duration, NIfty return can just about be anything: -10% to +25% or a wider spread.
Over twenty years, the spread is lower, not because the risk is lower, but because the history is lower. S&P 500 20Y SIP returns vary from 8% to 1% in the last 40 years. See: Do not expect returns from mutual fund SIPs! Do this instead! You would have seen this problem while trying to compare equity fund returns with PPF. Sometimes it is lower than PPF (over 15Y) and sometimes higher: 15-year SIP returns for 71 out of 148 equity MFs is less than 10%.
This means sometimes an equity fund would give fixed income-like returns and sometimes higher. A classification scheme where the constituents keep changing bins is not of much use. Therefore mutual funds cannot and should not be classified in terms of returns. After disciplined SIP investing over the long term in a distributor recommend mutual fund, the return from a midcap fund may not be higher than an overnight fund.
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A mutual fund classification scheme will have to be done in terms of a stable parameter. The natural choice is the day to day up and down fluctuation in the NAV or the volatility. This is measured using the standard deviation. We compute daily returns over a given period; compute the average of these daily returns and determine how much each daily return deviates from the average; Too much deviation = high standard deviation = high volatility.
There are two problems classifying mutual funds in terms of risk though. (1) the standard deviation only takes into account visible risks; There are many invisible risks like credit risk; mass redemption risk; re-investment risk etc. (2) The standard deviation itself is a quantity that ideally works only when the spread in returns fall on a “bell curve” and this is not the case for market returns.
In spite of these limitations, if the investor can qualify (or partially quantify) invisible risk separately, the standard deviation offer a simple, stable way to bin mutual funds. Stable because, whether we study funds over one year or ten years, there would not be much deviation in the category positions.
The SEBI mutual fund classification has put a spoke in the analysts’ wheel. Since funds reclassified themselves to fall in line with the regulator, new categories have to be accounted for and the duration available for the study is only about two years (June 2018 onwards).
Let us first appreciate the difficulty with categorizing mutual funds in terms of returns. This is a list of MF category and last two years median category returns. The median represents the centre of the return distribution and can be used even if the distribution is not bell-shaped or Gaussian (it is not).
- Credit Risk Fund 3.5%
- Overnight Fund 4.9%
- Value/contra/Div Yield Funds 4.9%
- Small cap Fund 5.5%
- Liquid 5.9%
- Arbitrage Fund 5.9%
- Equity Linked Savings Scheme 6.6%
- Ultra Short Duration 7.3%
- Equity Savings 7.4%
- Money Market 7.6%
- Low Duration 7.7%
- Dynamic Asset Allocation 7.8%
- Aggressive Hybrid Fund 7.9%
- Conservative Hybrid Fund 7.9%
- Multi-Cap Fund 8.0%
- Large Cap Fund 8.7%
- Large & Mid Cap 8.7%
- Medium Duration 8.7%
- Global 8.8%
- Focused Fund 8.9%
- Floating Rate 9.2%
- Balanced Advantage 9.4%
- Short Duration 9.9%
- Mid Cap Fund 10.1%
- Multi Asset Allocation 10.5%
- Corporate Bond 10.7%
- Dynamic Bond 11.1%
- Banking and PSU Fund 11.3%
- Medium to Long Duration 12.3%
- Short & Mid Term 12.6%
- Gilt Fund with 10 year constant duration 14.9%
- Long Duration 15.2%
So the categories with increasing 2Y returns are (just 10 shown)
- Credit Risk Fund
- Overnight Fund
- Value/contra/Div Yield Funds
- Small cap Fund
- Liquid
- Arbitrage Fund
- Equity Linked Savings Scheme
- Ultra Short Duration
- Equity Savings
- Money Market
This means the category median 2Y return of Money Market funds is currently greater than ELSS funds, Value funds etc.
Now let us repeat the exercise for seven years (just 10 shown)
- Arbitrage Fund
- Liquid
- Credit Risk Fund
- Ultra Short Duration
- Equity Savings
- Floating Rate
- Dynamic Bond
- Corporate Bond
- Banking and PSU Fund
- Conservative Hybrid Fund
The 2Y median return list is completely different from the 7Y. This much variation makes classifying mutual funds in terms of returns impossible
let us try using the median standard deviation. Categories are listed in terms of increasing standard deviation.
- Overnight Fund
- Liquid
- Arbitrage Fund
- Ultra Short Duration
- Money Market
- Floating Rate
- Low Duration
- Short Duration
- Banking and PSU Fund
- Corporate Bond
This is means corporate bonds are the most volatile among the other debt funds listed above. Now if we did this exercise over seven years, this is what we get. Recall overnight funds were part of liquid funds before mid-2018. Money market funds were part of ultra-short duration funds, short and medium durations did not exist.
- Liquid
- Arbitrage Fund
- Ultra Short Duration
- Floating Rate
- Banking and PSU Fund
- Corporate Bond
- Credit Risk Fund
- Dynamic Bond
- Conservative Hybrid Fund
- Equity Savings
In spite of new categories, the two lists are not too different. The sequence of increasing volatility: Liquid fund < Arbitrage fund < Ultra Short < Floating Rate < Banking, PSU < Corporate Bond is still preserved. More importantly, you can immediately tell the funds in the “ten” are not too different in terms of asset allocation.
That is if you use returns to classify equity funds are jumbled in with debt funds, arbitrage funds and hybrid funds. This can be avoided with standard deviation. The full list is given below.
In summary, mutual funds cannot and should not be classified in terms of returns. Day to day fluctuations in the NAV as measured with the standard deviation is a better measure, however, invisible risk like credit risk, reinvestment risk etc should be factored in separately. We shall consider this in a future article.
Mutual Fund Categories Classified With Standard Deviation (2y Median)
The number in percentage represent standard deviation not returns.
- Overnight Fund 0.09%
- Liquid 0.13%
- Arbitrage Fund 0.19%
- Ultra Short Duration 0.23%
- Money Market 0.25%
- Floating Rate 0.46%
- Low Duration 0.66%
- Short Duration 0.67%
- Banking and PSU Fund 0.78%
- Corporate Bond 0.81%
- Dynamic Bond 0.99%
- Medium to Long Duration 1.03%
- Medium Duration 1.04%
- Short & Mid Term 1.20%
- Gilt Fund with 10 year constant duration 1.36%
- Credit Risk Fund 1.44%
- Long Duration 1.78%
- Conservative Hybrid Fund 1.99%
- Equity Savings 3.06%
- Dynamic Asset Allocation 3.47%
- Balanced Advantage 4.48%
- Multi Asset Allocation 4.79%
- Aggressive Hybrid Fund 5.32%
- Global 6.05%
- Large Cap Fund 6.69%
- Multi-Cap Fund 6.81%
- Focused Fund 6.92%
- Equity Linked Savings Scheme 6.95%
- Value/contra/Div Yield Funds 6.99%
- Large & Mid Cap 7.15%
- Mid Cap Fund 7.45%
- Small cap Fund 8.60%
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