Risk

SEBI risk category

All AMCs have to assign one of 5 risk categories defined by SEBI to their MF strategies. The rating is assigned based on the level of risk of the strategy.

The 5 levels of risk defined by SEBI are :

  • Low – principal at low risk
  • Moderately Low – principal at moderately low risk
  • Moderate – principal at moderate risk
  • Moderately High – principal at moderately high risk
  • High – principal at high risk

For eg : The small cap fund managed by your friend’s AMC would be categorized as “High risk” as equity as an asset class is volatile, on the other hand the corporate bond fund that invests most of its funds into AA & above rated bonds issued by corporates would be categorized as “moderate risk” as the risk to capital invested is much lower than equity strategies.

Tracking error

An important metric for Index funds. From a broad perspective, it is the annualized standard deviation of the difference in returns between the fund and its respective benchmark.

The purpose of an index fund is to track the benchmark one to one in terms of both volatility and performance. Theoretically the best tracking error is 0, but costs related to handling and managing funds lead to non zero tracking errors. A low tracking error should be looked for when investing into any index fund.

Volatility/ Standard deviation

Standard deviation shows how dispersed the returns of the fund are over a specific horizon relative to the mean. Standard deviation & volatility are used synonymously. 

A lower standard deviation doesn’t always mean that the fund is better thus the metric should not be looked at alone. For eg : Fund A has a standard deviation of 15% and a return of 20% ( annualized figures ), on the other hand, Fund B has a standard deviation of 12.5% and a return of 10% ( annualized figures ): We can see that even though Fund B is less volatile, the returns are half of that of Fund A.

Standard deviation should be looked at along with other factors like returns over different horizons. Different categories of funds will have different standard deviations. Small Cap funds are generally more volatile and thus have higher standard deviation than large cap funds, but they also have different return profiles.

Category standard deviation

Category standard deviation, as the name states, is the average of standard deviation of all the funds in a particular category.

For eg : Let’s assume there are 5 funds in the small cap category :

Fund Std Dev
A 15%
B 17.5%
C 20%
D 22.5%
E 25%

This makes the category Standard deviation : (15%+17.5%+20%+22.5%+25%)/5 = 20%

We can use the Category standard deviation to compare individual funds to the average to see where the fund stands in terms of volatility in its category.

Maximum Drawdown

A maximum drawdown (MDD) is the maximum observed loss from a peak to a trough of a portfolio, before a new peak is attained. Maximum drawdown is an indicator of downside risk over a specified time period.

The metric is used to assess the relative riskiness of a strategy to another.

It focuses on capital preservation and funds with a lower MDD (keeping other factors constant) are better. 

For eg : There are 2 funds 

Fund A : Standard dev : 12.5%, Average returns : 15% & MDD = 25%

Fund B : Standard Dev : 12.5%, Average returns : 15% & MDD = 30%

Fund B should be chosen over fund A based on these metrics.