A 5 YEAR PERSPECTIVE TO RISK ADJUSTED RETURNS

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Point to point returns or CAGR returns are the most popular way to assess mutual fund performance. Of course, if it is a systematic investment plan (SIP), then extended internal rate of return (XIRR) is a better measure. But all these measures have a shortcoming, in that, they do not factor in risk. Why does risk or volatility matter? Let us put a rhetorical question. Would you prefer a fund that gives 14% returns with 12% standard deviation or a fund that gives 16% returns with 33% standard deviation. You obviously prefer the former, since it has lower risk adjusted returns. Here we look at 5-year risk adjusted returns to understand which categories have done the best in terms of returns adjusted for risk. For simplicity, we have used the range instead of standard deviation as a measure of dispersion. Each category has then been ranked on risk-adjusted returns. Here are the five key categories.

CAPITALIZATION FUNDS: RANKING ON 5-YEAR RISK ADJUSTED RETURNS

Here we rank various categories of capitalization funds on risk-adjusted returns; for the 5 years to December 2024.

Data Source : Morningstar

You can almost call it anomalous that large cap funds have outperformed on risk-adjusted returns over a 5 year period. However, this is less about higher returns and more about lower volatility risk. Small cap funds rank much lower as the returns have not been able to justify the sharply higher volatility. Among capitalization categories, multi-cap funds continues to outperform flexi-caps; as the markets turn averse to manager discretion.

EQUITY THEMATIC FUNDS: RANKING ON 5-YEAR RISK ADJUSTED RETURNS

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Here we rank various categories of thematic funds on risk-adjusted returns; for the 5 years to December 2024.

Data Source : Morningstar

The good news is that all the 11 categories of thematic funds have given positive average returns over a 5-year period. Once again, FMCG funds and ESG funds score on top; less due to returns and more due to low volatility risk. Technology is the sector that earned the best CAGR returns over 5 years, and manage to more than compensate for the higher levels of volatility risk. ELSS funds, focused funds, and Infrastructure funds figure in the bottom due to a much higher volatility risk and the heterogeneity of funds within the category.

HYBRID ALLOCATION FUNDS: RANKING ON 5-YEAR RISK ADJUSTED RETURNS

Here we rank various categories of hybrid allocation funds on risk-adjusted returns; for the 5 years to December 2024.

Data Source : Morningstar

There are two quick takeaways from the hybrid allocation fund story. Balanced allocation funds, being formula based funds lead the category due to low risk levels. However, the discretionary allocation funds like dynamic allocation funds (BAFs) and equity savings funds have done well as they have used the low depreciation of contrasting asset classes to reduce risk and enhance the risk adjusted returns in this case.

ACTIVE DEBT FUNDS: RANKING ON 5-YEAR RISK ADJUSTED RETURNS

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Here we rank various categories of active debt funds on risk-adjusted returns; for the 5 years to December 2024.

Data Source : Morningstar

What is driving risk-adjusted performance in active debt funds. There are several key takeaways from the ranking above. Tenure or duration of the fund does not really matter. For instance, at the top is the 10-year Government Fund, followed by Money Market fund at the short end of the curve. However, pure discretion based allocation in debt funds has not worked as it raises the risk, without raising the returns commensurately. That explains why dynamic bond funds, medium duration, and low duration funds figure at the bottom on risk-adjusted returns. Incidentally, floating rate funds and credit risk funds delivered the best returns, although volatility risk was elevated too.

ALTERNATE FUNDS: RANKING ON 5-YEAR RISK ADJUSTED RETURNS

Here we rank various categories of alternate funds on risk-adjusted returns; for the 5 years to December 2024.

Data Source : Morningstar

We have considered 3 categories of fund here viz. precious metals, arbitrage funds, and liquid funds. As has been the experience in the past, precious metals funds have outperformed this time too. Gold scores high on returns and also on risk, making it, perhaps, the best among all fund categories on risk-adjusted returns.

Risk adjusted returns approach forces funds to optimize returns. If it is not possible to boost returns, the focus should be to control the risk. If you look at most categories, the leadership is less about chasing returns and most about managing the risk effectively. When risk is managed effectively and volatility is reduced, even mediocre returns get magnified. Low volatility, limited fund manager discretion, and a rule-based approach seem to be best themes!