Best mutual fund categories by risk adjusted returns

22 Sep 2024 , 09:39 AM

 

WHY DO WE LOOK AT RISK ADJUSTED RETURNS?

Mutual fund ranking on returns is quite common. You use yearly returns for 1-year returns and CAGR returns for longer time period to factor in the compounding effect. However, returns are just one side of the story. Let us understand this point better. Which is better between two similar funds; a fund that gave 16% returns or a fund that gave 14% returns? Obviously, your choose the former for the higher returns. Let us now qualify this statement further. The second fund earned 14% with 10% volatility while the first fund earned 16% with 35% volatility. Now, the second fund is starting to look more attractive. Why is that?

Your obvious inference is that the first fund that gave 16% has taken an undue amount of risk to generate the additional 200 bps of returns. That is like playing ducks and drakes with investor money and not a very prudent thing to do. Today, there are standard measures like the Sharpe and Treynor that help us to rank funds based on the risk-adjusted returns. You not only look at returns, but ensure that the risk levels are optimal and not inordinately high. High risk means high volatility and that means the performance of the fund becomes inconsistent over a period of time. That makes the fund more vulnerable to timing of entry and exit, which should not be the case. That is why risk adjusted returns matter.

HOW DO WE MEASURE RISK ADJUSTED RETURNS?

In the traditional approach to risk adjusted returns, the excess returns are divided by the standard deviation (which is a measure of dispersion). However, here are not looking at specific funds but we are only looking at specific categories of funds. Hence, we will look at a simpler measure of dispersion which is the range. So, the total average returns of the fund category will be divided by the value range of that category. This may not be a very precise way to measure risk-adjusted returns but it should give adequately correct results. We will look at these risk adjusted returns analysis for 4 categories of funds viz., Income Funds (debt funds), equity funds, Hybrid Funds (Allocation Funds) and Alternative funds that do not fit into any of the above categories. We have used a 7 year time period to assess risk adjusted returns as that is the period when negative returns on equity are almost eliminated.

BEST PERFORMING DEBT FUND CATEGORIES ON RISK ADJUSTED RETURNS

The table below ranks the various categories of debt funds or income funds based on risk-adjusted returns. We have already explained risk adjusted returns in the preceding paragraph. The risk adjusted return on its own does not have any significance but it is purely for ranking and for comparison within the category.

Debt Fund Categories	Average Returns (%)	Best Returns (%)	Worst Returns (%)	Return Range (%)	Risk-Adjust Returns (X)
10 yr G-Sec Bond	9.39	10.49	6.53	3.96	2.3712
Long Duration	10.18	12.19	4.57	7.62	1.3360
Med/Long Duration	8.65	9.96	3.32	6.64	1.3027
Government Bond	9.24	12.46	3.48	8.98	1.0290
Floating Rate	7.74	10.25	1.34	8.91	0.8687
Money Market	6.56	7.89	0.00	7.89	0.8314
Medium Duration	7.78	10.51	0.36	10.15	0.7665
Banking & PSU	6.85	9.70	0.02	9.68	0.7076
Short Duration	7.34	11.01	0.56	10.45	0.7024
Low Duration	6.53	9.57	0.08	9.49	0.6881
Corporate Bond	7.44	14.51	3.63	10.88	0.6838
Credit Risk	8.20	17.65	-0.05	17.70	0.4633
Dynamic Bond	8.78	12.17	-8.78	20.95	0.4191
Ultra Short Duration	6.38	8.30	-15.30	23.60	0.2703

Data Source: Morningstar India

What are the key takeaways from the ranking of debt funds (income funds) above? Remember, risk adjusted returns is purely for comparison purposes only. Here is what we inferred from the rankings above.

• Even over a 7 year analysis period, there are 3 categories of debt funds viz. ultra short term funds, dynamic bond funds and credit risk funds that have worst returns in the negative zone.
• In terms of average returns among the various debt fund categories, the 10-year government bond funds and the long duration funds ranked on top in terms of average returns and risk adjusted returns. Clearly, tapering yield shave helped long duration.
• At the bottom in terms of risk adjusted returns are credit risk funds, dynamic funds, and ultra short term duration funds. These are the funds where asset quality questions were quite apparent amidst the greater leeway given to the fund managers.
• If you take the debt fund category as a whole, the mean returns across categories averaged 7.93%. The maximum returns across various debt fund categories averaged 11.19%, while the minimum returns across debt fund categories averaged -0.02%.

Debt funds have not had  a great period overall and that is evident from the wide variations in performance across categories. The moral of the story is that discretion in debt has not worked too well for investors.

BEST PERFORMING EQUITY FUND CATEGORIES ON RISK ADJUSTED RETURNS

The table below ranks the various categories of active equity funds or growth funds based on risk-adjusted returns. We have already explained risk adjusted returns. The risk adjusted return on its own does not have any significance but it is purely for ranking and for comparison within the category of equity funds here.

Equity Fund Categories	Average Returns (%)	Best Returns (%)	Worst Returns (%)	Return Range (%)	Risk-Adjust Returns (X)
Contra	50.23	54.33	40.56	13.77	3.6478
Sector – Healthcare	51.79	61.20	46.20	15.00	3.4527
Equity- Infrastructure	54.91	73.69	45.60	28.09	1.9548
Sector – FMCG	19.95	22.57	11.79	10.78	1.8506
Large-Cap	34.50	48.10	29.37	18.73	1.8420
Sector – Technology	33.10	48.15	30.02	18.13	1.8257
Dividend Yield	43.82	60.43	36.18	24.25	1.8070
Multi-Cap	42.79	56.29	30.74	25.55	1.6748
Value	44.28	69.26	36.42	32.84	1.3484
Equity – ESG	33.89	51.44	23.40	28.04	1.2086
Mid-Cap	47.90	72.27	30.99	41.28	1.1604
Small-Cap	45.51	77.40	35.30	42.10	1.0810
Large & Mid- Cap	42.92	63.43	20.40	43.03	0.9974
ELSS (Tax Savings)	38.35	69.87	26.17	43.70	0.8776
Flexi Cap	39.68	61.52	14.35	47.17	0.8412
Focused Fund	39.18	75.14	26.39	48.75	0.8037
Sector – Financial	20.21	50.93	17.39	33.54	0.6026

Data Source: Morningstar India

What are the key takeaways from the ranking of equity funds above? Remember, risk adjusted returns is purely for comparison purposes only. Here is what we inferred from the rankings above.

• Over a seven year period, there are really no categories of equity funds with negative returns. The worst performer is the FMCG sector which has worst case returns of 11.79% CAGR over a 7 year period. Let us now turn to the gainers and the losers.
• In terms of average returns among the various equity fund categories, contra funds, healthcare funds, and the infrastructure ranked on top in terms of average returns. Both contra funds and healthcare funds also gained from low risk levels, a sign of consistency.
• At the bottom in terms of risk adjusted returns are financial services fund, focused funds, flexi cap funds and ELSS funds. ELSS funds are losing their relevance with the new tax regime while flexi caps are another case of discretion to the fund manager not living up to the name. Retail favourites like mid-cap and small cap funds are in the middle due to their high risk component.
• If you take the equity fund category as a whole, the mean returns across categories averaged 40.18% over the 7-year period. The maximum returns across various equity fund categories averaged 59.77%, while the minimum returns (worst case returns) across equity fund categories averaged 29.49%. That explains why equity funds are a financial planning favourite over the long term.

Clearly, the last 7 years have belonged to the equity funds, largely due to the frenetic recovery from the lows of the pandemic. Equity funds had  a great period overall and that is evident from the from the fact that even worst case returns across equity fund categories over the last 7 years have averaged a whopping 29.49%. The moral of the story is that discretion in equity may not have worked too much, but focused themes surely have.

BEST PERFORMING HYBRID CATEGORIES ON RISK ADJUSTED RETURNS

The table below ranks the various categories of hybrid (allocation) funds based on risk-adjusted returns. The risk adjusted return on its own does not have any significance but it is purely for ranking and for comparison within the category of allocation (hybrid) funds here.

Hybrid Fund Categories	Average Returns (%)	Best Returns (%)	Worst Returns (%)	Return Range (%)	Risk-Adjust Returns (X)
Balanced Allocation	20.08	25.92	17.08	8.84	2.2715
Aggressive Alloc.	30.74	51.65	21.58	30.07	1.0223
Conservative Alloc.	12.72	19.72	4.42	15.30	0.8314
Equity Savings	15.47	26.60	7.56	19.04	0.8125
Dynamic Allocation	23.86	54.02	14.99	39.03	0.6113

Data Source: Morningstar India

What are the key takeaways from the ranking of hybrid ( allocation) funds above? Remember, risk adjusted returns is purely for comparison purposes only. Here is what we inferred from the rankings above.

• Over a seven year period, there are really no categories of funds with negative returns. The worst performer is the Conservation Allocation category which has worst case returns of 4.42% CAGR over a 7 year period. That is still in positive territory only.
• In terms of average returns among the various hybrid fund categories, balanced allocation and aggressive allocation funds ranked on top in terms of average returns and risk adjusted returns. Both these categories of funds gained from a more rule based allocation and the low risk was especially apparent in balanced allocation funds.
• At the bottom in terms of risk adjusted returns are dynamic funds and equity savings funds. Both are allocation funds that offer an alternate to financial planning but also offer a high level of discretion to the fund manager. Interestingly, the dynamic allocation funds (balanced allocation funds – BAFs) are high on average returns but rank lowest on risk adjusted returns due to the high level of volatility in the returns.
• If you take the hybrid (allocation) fund category as a whole, the mean returns across categories averaged 20.57% over the 7-year period. The maximum returns across various hybrid fund categories averaged 35.58%, while the minimum returns (worst case returns) across hybrid fund categories averaged 13.13%. That is a reasonably good performance in terms of all categories of returns.

If you are wondering why the allocation funds or hybrid funds have taken off in a big way in the last few years, they have carved a niche. The growth in hybrid funds has not only been in terms of the AUM but also in terms of the number of folios, which shows the retail spread. All the categories of hybrid funds have given positive returns even in a worst case scenario, which is the positive takeaway.

BEST PERFORMING ALTERNATE CATEGORIES ON RISK ADJUSTED RETURNS

The table below ranks the residual alternate funds based on risk-adjusted returns. The risk adjusted return on its own does not have any significance but it is purely for ranking and for comparison within the category.

Alternate Fund Categories	Average Returns (%)	Best Returns (%)	Worst Returns (%)	Return Range (%)	Risk-Adjust Returns (X)
Gold Funds	22.61	24.48	20.57	3.91	5.7826
Arbitrage Funds	7.41	8.63	4.76	3.87	1.9147
Liquid Funds	6.02	19.55	-0.69	20.24	0.2974

Data Source: Morningstar India

What are the key takeaways from the ranking of alternate funds above? This is not any identified category, but all funds not technically forming part of the first 3 categories have been clubbed here. Here are some key inferences that we could draw.

• Over a seven year period, there is just one category of liquid fund which has an instance of negative returns. Incidentally, liquid funds category has worst case returns of -0.69% CAGR over a 7 year period. That can be attributed to piling on unnecessary short term portfolio risk in the case of liquid funds.
• In terms of average returns among the various alternate fund categories, gold funds have proven to be the star performer. Gold funds have not only done well in terms of returns, but their returns are so consistent that the risk levels are very low and that is boosting the risk-adjusted returns. As a result, the gold funds are the best performing category over 7 years across all fund categories, primarily due to low volatility risk.
• At the bottom in terms of risk adjusted returns is liquid funds where the reason appears to be a handful of funds compromising on the quality of the liquid funds with high risk assets that are not exactly liquid. Return or alpha hunting has not worked too well for debt funds; either at the short end or the long end of the yield curve.
• If you take the alternate fund category as a whole, the mean returns across categories averaged 12.01% over the 7-year period. The maximum returns across various alternate fund categories averaged 17.55%, while the minimum returns (worst case returns) across alternate fund categories averaged 8.21%. That is a reasonably good consistency, although we cannot draw too many inferences due to being a residual category of funds.

If you look back at the last 7 years, it has belonged to the equity funds followed by the hybrid or the allocation funds. Income funds have not had a great time, either in terms of returns on in terms of managing risk. The equity funds and hybrid funds have generated the best risk-adjusted returns over a seven year period and that explains why the flows are gravitating towards these funds. As the seven year story goes, there are no negative return categories in equity and hybrid funds, clearly indicating that when it comes to mutual funds, time still does matter a lot more than timing!