Every mutual fund investment decision is a risk-return trade off. Basic finance teaches us that higher returns are associated with higher level of risk undertaken. Thus higher the level of risk that you undertake the higher is the return that is expected by you. If you go lower down the risk scale, then there are less returns on the offing. Let us understand the steps to grading risk and returns when it comes to mutual funds.
Steps to grading mutual funds on the risk return scale..
We need to understand the 4 steps to risk-return trade-off in mutual funds as under:
Step 1: At the lowest end of the spectrum are the liquid funds. These funds typically invest in very liquid asset classes like call money, government treasury bills, certificates of deposit, commercial paper etc. These are virtually risk free and since they are short term instruments, they are less vulnerable to movements in the interest rates. The products they invest in are government backed instruments where the default risk is almost nothing.
Step 2: At the second level are the debt funds. Debt funds become risky for two reasons. Firstly, they are long term funds. They invest in long dated government securities. While these government securities are still free of default risk, they are prone to interest risk. In fact, longer the maturity greater is the vulnerability to shifts in interest rates. Secondly, debt funds invest in a mix of government securities and corporate debt. These corporate debt instruments do run a major price risk as we saw in the case of Amtek Auto.
Step 3: At the third level are the hybrid funds. A classic example of a hybrid fund is a balanced fund. Balanced funds invest in a mix of equity and debt instruments. As a result, the returns on these funds are slightly higher than debt funds but lower than pure equity funds. The major attraction of balanced funds is that despite a 35% exposure to debt, they are classified as equity funds for the purpose of calculating tax on capital gains. That makes them more attractive in post-tax terms.
Step 4: At the highest level are the equity funds which are predominantly invested in equities. Of course, equity funds do try to reduce your overall risk by diversifying across asset classes and sectoral exposures. But equity, being an instrument that does not offer assured returns, is more risky than debt. Even within the gamut of equity funds, the sector funds and thematic funds tend to be more risky as they are more vulnerable to specific risks and do not bring the benefit of diversification.
Dissecting the risk-return trade-off in granular detail..
There is a unique aspect of the risk-return trade-off that you need to understand. Higher returns entail higher risk but then higher risk does not automatically entail higher returns. Therefore you have to choose your risk properly. That lies at the core of the risk trade-off. For example, diversification reduces risk provided you combine assets that are different. If you keep adding the same kind of asset then you are only substituting your risk and not reducing it. The second aspect pertains to inclusion of equity. If you add equity to your portfolio and add only banking and realty stocks then you are taking a huge bet on interest rates going down. In fact, if rates go up, then your portfolio may give lower returns despite taking on higher risk.
A better way to manage your risk-return trade off is through systematic investment plans (SIP). How does a SIP help in this case? Since SIPs are phased they give you the benefit of rupee cost averaging. Additionally, you are not committing all your funds in one single go and are able to keep your options open. The SIP not only protects you with the luxury of afterthought but also reduces your overall cost in volatile markets.
Asset Allocation as risk-return defence mechanism..
The best way to manage your risk-return trade-off is through asset allocation. This is about deciding the percentage allocation for each asset class. This is normally done in the form of bands. Once the band is exceeded on either side, your asset allocation shift is automatically triggered. So profits are constantly booked and at higher valuations and lower prices lead to higher allocation. This is your best defence and helps you play the risk-return trade off in the best possible manner.
The crux of the story is that all investments entail risk. Your job is not only to manage the risk but also leverage the risk for higher returns. In his landmark book, "Against the Gods", Peter Bernstein rightly says that all progress in the 20th century is due to our superior understanding of risk". That is what this risk-return trade-off is all about!