Want mutual funds with lower risk & higher return? Try this easy method!

Image of a lens filter focussing on a building representative of mutual fund screeening with lower than benchmark risk and higher than benchmark return

Published: June 15, 2020 at 10:34 am

Last Updated on

Do you want mutual funds that have got a higher return than a benchmark at lower risk? Then here is an easy way to spot them!

In order to do this, let us first define “return”. This is easy, we will just use the annualized return aka compounded annualized growth rate (CAGR) aka IRR aka XIRRThen we define “risk”.

Unlike return, risk can be defined in many ways. The simplest and most common measure of risk is the standard deviation. We look at a mutual fund’s daily returns and determine how much they deviate from the average daily return over say a year or three years. This tells us how volatile the fund is.

So we shall define a fund with lower risk as one with a lower standard deviation than a benchmark. That is lower volatility than a benchmark. We shall define a fund with higher return as one with a higher return than a benchmark (obviously!)

The question now is, how do we screen for funds with lower risk and higher returns.  First, we need to decide on the duration. How about funds with lower risk and higher returns over the last 1,2,3,4 and 5 years? That is a reasonably robust filter. The goal with any screening is to reduce the number of funds, but it should not reduce it down to one or two funds as such a list will be too variable.  The above conditions get the job done well.

Shortlisting mutual funds with lower risk and higher return

Let us consider the data over the last five years. We have 368 equity funds in the basket, to begin with. We first define the Excess return of the fund = Five-year return of the fund minus the five-year return of the index. So, if the excess return is positive it means the fund has beat the index and vice versa.

Next, we define the Excess risk of the fund = Five-year standard deviation of the fund minus five-year standard deviation of the index. So if the excess risk of the fund is negative it means the fund has taken lower risk than the index and vice versa.

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Clearly, we are looking for funds with positive excess return and negative excess risk. Such funds would have beat the benchmark by taking a lower risk. Suppose we plot the excess return (vertical axis) vs the excess risk of all the funds, we would get this.

Shortlisting mutual funds with lower risk and higher returnWe now have four sections. Among these, clearly the one marked in red – lower return and higher risk is a  No-no. The rest are okay, but the ones within the blue rectangle – higher return and lower risk are special. All the funds here are exactly what we are looking for.

This is however only over five years. We can make this a lot tighter by demanding that funds beat the benchmark at lower risk over 1,2,3,4 and 5 years. For June 2020, this results in only 8 funds across these categories.

Category No of qualifying funds
Focussed Fund 1
Large Cap Fund 2
Multi-Cap Fund 1
Mid Cap Fund 4

This lower risk, higher reward screening is automatically applied in the freefincal equity mutual fund screener. This is a video guide for using the screener.

 

To obtain the monthly shortlist of funds with lower risk and higher return, readers may consult our monthly mutual fund screeners (latest would be the first on the list). In addition to the above screening,

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About the Author Pattabiraman editor freefincalM. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. since Aug 2006. Connect with him via Twitter or Linkedin Pattabiraman has co-authored two print-books, You can be rich too with goal-based investing (CNBC TV18) and Gamechanger and seven other free e-books on various topics of money management. He is a patron and co-founder of “Fee-only India” an organisation to promote unbiased, commission-free investment advice. He conducts free money management sessions for corporates and associations on the basis of money management. Previous engagements include World Bank, RBI, BHEL, Asian Paints, Cognizant, Madras Atomic Power Station, Honeywell, Tamil Nadu Investors Association. For speaking engagements write to pattu [at] freefincal [dot] com
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