Can Mutual Fund risk be quantified and can it be eliminated?

 

Of late, we have been bombarded with endless ads of “Mutual Fund Sahi hai”. And all of them end with a standard disclaimer – “Mutual fund investments are subject to market risks. Please read the offer document carefully before investing”. What does that even mean? Is it just a mandatory disclaimer or something that needs to be taken seriously?

Short answer – do NOT ignore the risks. Investing in Mutual Funds (especially Equity Mutual Funds) is fairly risky.

Does that mean you simply stop investing in Equity MF and go back to good old Fixed Deposits? Not at all! If backed by a proper risk-mitigation strategy, Equity MFs are by far the best instruments for creating long-term wealth. Stick to them, but with a plan.

Before we move on, let’s take a step back and quickly revisit the concept of risk and returns.

How do we quantify risk?

Risk associated with an investment, in very simple terms, can be defined as follows – the chance that the actual return on your investment will vary from the expected return.

For example, say you purchase mutual fund units worth Rs 10,000 today and plan to withdraw your money in 3 years. Assuming that this scheme has historically yielded an average annual return of 15% (if held for 3 years), your expected return from this investment will be 15%. In other words, you would expect your money to grow to Rs 15,209 in 3 years time. Your risk here is the chance that your investment will be worth less than Rs 15,209 in 3 years time. Higher this chance is, more risky is your investment

But how do we quantify this chance? We use a metric called standard deviation (which measures volatility) of returns. Without getting into technicality, lets just understand standard deviation with an example.

If a fund has a 3-year average return of 15% and 3-yr standard deviation of 10%, it means that if you invest in this fund today, there is a 95% probability (chance) that the return in 3 years time will be between -5% (15% – 2 x 10%) and 35% (15% + 2 x 10%). Higher the standard deviation, higher is the risk associated with the fund.

How real is the risk?

Now that you have understood the underlying math of risk and return, let’s try to quantify the risk associated with investing in Equity MFs.

Consider this equity mutual fund called ICICI Value Discovery Fund. Suppose you invest in this fund for a 1-year holding period.

Historically (for data from April 2006), average 1-year return of this fund has been 23% and a standard deviation of 42%. What does this mean? There is a 95% probability of your actual 1-year return being in the range of -61% (23% – 2 x 42%) to +107% (23% + 2 x 42%).

That is huge volatility. And there in lies your risk. If you are lucky, you end up with great returns. If you are not, you might end up losing money. In fact, there is close to 30% chance that your returns will be negative. So essentially, this is punting and NOT investing.

But didn’t you know that already? Haven’t you always been told that Equity Mutual Funds should be held for long term?

All right. So lets see what happens if you hold on to your investment for periods longer than 1 year?

What about a 3-year holding period?

3-year average return of this fund is 21% and standard deviation is 11%. A significant reduction in standard deviation as we move from 1 year to 3 years. Importantly, chances of negative return falls drastically to 3.4%. That’s a significant improvement!

Does it get better with a 5-year holding period?

It does! 5-year average return of this fund is 19% and standard deviation is 6%. Chances of negative return falls down to 0.1%. So you are pretty much assured of your principal.

As you move beyond 5-6 years, the probability of negative returns on your MF investment is to a large extent eliminated. But you are not investing in equities just to avoid negative returns. Ideally, you should expect your equity investments to deliver at least 14-15% returns in an emerging economy like India. Unfortunately, even with a holding period as high as 5 years, chances of earning less than 15% is as high as 27%.

Just to recap, here is a quick summary of all the above scenarios:

Holding PeriodMeanStandard DeviationChances of negative returns Chances 15% plus returns
1 Year23%42%30.0%57%
3 years21%11%3.4%70%
5 Years19%6%0.4%73%

As we can see, there is a clear pattern here – increasing the holding period brings down the risk. But the fact remains that even with a top-rated fund and a 5-year holding period, chances of earning less than 15% is as high as 27%. Is there a way to compress this risk further? The good news is that you can do much better.

Finpeg’s revolutionary SDC approach

At Finpeg, we follow a time-tested SDC (Standard Deviation Compression) approach, which comprehensively covers when to invest, redeem and rebalance. By running millions of simulations, we arrive at an optimal combination of entry strategy, holding period and an exit strategy that maximizes returns and minimizes risk.

In this approach, your investment is broken up into a large number of micro-investments that are staggered and deployed in a customized Model Portfolio as per a timeline governed by our algorithms. Similarly, the investment proceeds are broken up into a large number of micro-redemptions that are again staggered as per our algorithms.

The end result…

With Finpeg, you can target the same 20% return, but this time with standard deviation as low as 2%. That is some phenomenal risk compression, isn’t it?

In other words, Finpeg can enable you to target a return range of 16% – 24% with a staggering 95% probability. Lower end of the range at 16%! Now that’s something, right? That’s the kind of “risk compression” Finpeg can help you achieve.

Here is how your return range with 95% probability stacks up:

Return Range with 95% probabilityLower EndUpper End
Invest in NIFTY for 5 years-0.1%+17%
Invest in ICICI Value Discovery for 1 year-61%+107%
Invest in ICICI Value Discovery for 3 years-2%+44%
Invest in ICICI Value Discovery for 5 years+7%+31%
Invest with Finpeg+16%+24%

There you go! It’s a no-brainer really. If long-term wealth building is on your mind, Finpeg is your destination. Do get in touch.

NOTE: All projections and estimates above are based on past performance of scheme(s) between April 2006 and March 2017.

This article has 9 comments

  1. Dheeraj kr Reply

    The analysis is as clear as crystal and meaningful to an investor who does have money for investment but lacks his own understanding on the subject. All the best wishes to Finpeg team.

    • Shubham Satyarth Reply

      Hi Muralidhar,

      Its an important question and I am glad you asked it. Let me answer it in 2 parts – 1. What happens if Finpeg closes in 2 years (an event that is highly unlikely) and 2. Will Finpeg close in 2 years.

      1. What happens if Finpeg closes in 2 years:

      Although this is highly highly unlikely (and I will address this in part 2 of my answer), lets for the sake of argument assume it happens. What happens to your investments then? Well, they will be completely safe. When you invest with Finepg, all your investments are made in your name. So all the Mutual Fund units will be under your name. You can actually create individual logins on Mutual Fund Company’s websites and track your investment. So if after 2 years we close down, you can either redeem your investments directly from these Mutual Fund companies or continue to hold on to them and redeem whenever you want.

      For example, suppose you start investing with us and in 2 years time and you have units of scheme from HDFC Mutual Fund. If we shut down, you still hold the units of these funds. You can go to HDFC’s website (or you can contact them physically) and either redeem your units or continue your investments and redeem at an appropriate time.

      2. Will Finpeg close in 2 years

      As I said, this is next to impossible. We are already managing a pretty large amount of money and growing at over 50% per annum. So by the end of 2 years, we would be at least 4 times the size we are currently. We are not a local fly-by-night operator but an advisor with a global footprint. Our clients are spread across the globe. So the question of us closing down does not even arise.

      • Joseph. S Reply

        Thanks for answering that.
        This is a kind of conventional query which many beginners have and very much of concern initially even on small investment.

  2. Isht Vibhu Reply

    I am apprehensive and an investor with orthodox approach. I had many queries and doubts as I was more interested in doing a STP in direct plans, but thankfully Mr Anurag Bhalerao listened me very patiently and carefully and I stand convinced.

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