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One reason why you should invest in mutual funds than in stocks: Risk-adjusted Return
October 30, 2009

Risk should be rewarded with excess returns. This article explains how Sharpe ratio works and takes a closer look at the relative performance of stocks and mutual funds on a risk-adjusted basis.


Author : iFAST Research Team



Untitled Document
Chart 1
Chart 2: The Majority of Stocks Underperformed CNX 500 Index
Chart 3: Mutual Funds Have Delivered Better Risk-Adjusted Returns
Step 1: Use the fund selector function on our website to find Sharpe ratios
Step 2: Select the sector
Step 3: Information on Sharp Ratio can be found in the table.

KEYNOTES

  • Risk should be compensated with excess returns. Investors should not take too much risk for just a small increment of potential return.
  • Amongst the top 100 companies in CNX 500 Index as of 30 September 2009, none of them overperformed the CNX 500 Index during 2004 – 2009
  • Returns of mutual funds are higher than stocks on a risk-adjusted basis.

Some of you may think that investment is all about return. Return is the ultimate yardstick measuring the attractiveness of an investment. Let’s look at Table 1. Amongst the four investment products, which one would be the best pick? Apparently, the answer would be product B because it yields the highest return. But is our selection criteria simple as that?

Table 1 : Risk and Return Comparisons(Part I)
Investment Products Return (%) Volatility (%)
A 32.2 29.6
B 40.6 36.1
C 36.7 27.6
D 32.2 28.2
Source: iFAST Compilations

Don’t take too much risk for just a marginal increase in potential return!

In brief, risk-adjusted return is the amount of excess return you are compensated for each unit of risk you bear. Some of you may argue: why should we pay attention to the level of risks if the potential return of a stock is sufficiently high? The answer is that, a potential return is no more than a possibility which carries uncertainties. A higher uncertainty should be compensated with a higher potential return. In short, a higher risk goes with a higher potential return. Therefore, when evaluating investment products, one should expand their yardstick from one dimension (return) to two dimensions (return vs risk). Chart 1 illustrates a two-dimension matrix called Risk-Return Quadrant. A risk-averse investor should exhibit the following characteristics, 1. For two investments with the same risk level, investors would choose the one with the higher return over the lower one. 2. Similarly, for two investments with the same return, investors would choose the one with the lower risk (or volatility) over the higher one. That means investors would prefer Investment D to Investment A as shown in Table 1. Holding the above two characteristics constant, we can conclude that investors would favour investments lying in the top left corner of the quadrant (Chart 1).

Will each unit of risk taken be rewarded sufficiently with potential return?

To illustrate the concept of risk-adjusted return, let’s use shopping as an example. Take the potential return of an investment as the quality of the goods you purchase, and the risk as the price you pay for the goods. As a bargain hunter, you want to buy a product with the lowest price. There is a wide variety of products of different prices and quality, displaying on the shelf. You therefore would evaluate whether the price you pay is reasonably rewarded. Similarly, when comparing different investments, you wish to know which one offers you the best risk-reward ratio and Sharpe ratio is the right tool for you. This risk-adjusted return is calculated as: Sharpe Ratio = (Average Annualised Return – Risk-free Rate) / (Average Annualised Standard Deviation) The essence of Sharpe ratio is that it helps you evaluate the return of your investment for every unit of risk you bear. The higher the Sharpe ratio, the more you are rewarded for each unit of risk taken and thus the more attractive is the investment. The four mutual funds in Table 2 are identical to those depicted in Table 1. Here we evaluate each of their attractiveness using Sharpe ratio, assuming the risk-free rate is 3%. Clearly, Investment C becomes the best pick.

Table 2 : Risk and Return Comparisions(Part II)
Investment Products Return (%) Volatility(%) Sharpe Ratio (The higher the better)
A 32.2 29.6 0.99
B 40.6 36.1 1.04
C 36.7 27.6 1.22
D 32.2 28.2 1.04
Assuming risk-free rate is 3%Source: iFAST Compilations

Return is a one-dimension measurement matrix while risk-adjusted return is a two dimensional matrix with an inclusion of “risk”. As we all know, investors take risks for excess returns. Sharpe ratio provides you with a gauge for the amount of excess return you are rewarded for each unit of risk taken.

Do stocks reward you with a better return for the risk taken?

Chart 2 shows risks and returns distribution of the top 100 companies in CNX 500 Index as of 30 September 2009. The stocks below the green line generate a return lower than CNX 500 Index, while stocks under the red line underperform CNX 500 Index on a risk-adjusted basis. The all of the top 100 companies underperform the Index in terms of absolute return. The proportion of underperformance is even larger on a risk-adjusted basis as shown in the blue-shaded region. Although stocks in the blue region generate a higher return than the index, the amount of risk taken increases proportionately, suggesting a lower risk-return ratio. Therefore stocks are not good investments when compared with mutual funds.

Mutual funds have rewarded investors with better risk-adjusted returns

We conducted a similar analysis for the Equity diversified funds available in India as illustrated in Chart 3. 6 funds have given better returns on a risk-adjusted basis. Despite of their higher volatility, the three funds reward investors with a higher return on risk-adjusted basis. Moreover, while CNX 500 Index exhibited the lowest volatility when compared with stocks of top 100 companies (Chart 2), some mutual funds showed even lower volatility plus higher returns than CNX 500 Index on a risk adjusted basis, indicating their outstanding performances in both risk and return perspectives. 

Make sure the risk you take is sufficiently rewarded!

The financial tsunami taught us a lesson on risk. In 2008, we witnessed the fall of some of the industry leaders. A single stock indeed appears to be far more volatile than people have ever thought of, especially during market sell-off. Therefore, if you are concerned about risk and you wish the potential returns are rewarded with appropriate amount of risk, Sharpe ratio would offer you a good helping hand!

Conclusion: Mutual funds are better than stocks on a risk-adjusted basis

We have discussed how to compare risk-adjusted returns of different investments using Sharpe ratio. The risk-adjusted return of CNX 500 Index is higher than all the stocks of the top 100 companies. However, mutual funds with active management display larger risk-adjusted returns than CNX 500 does. Therefore, investing in mutual funds is better than stocks on a risk-adjusted basis.

Where can I find such information?

The best way to interpret Sharpe ratio is to compare funds with similar investment objectives. In this regard, we introduce the fund selector function on FSM website which allows you to select funds according to different categories. Steps are shown on the right:

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iFAST and/or its content and research team’s licensed representatives may own or have positions in the mutual funds of any of the Asset Management Company mentioned or referred to in the article, and may from time to time add or dispose of, or be materially interested in any such. This article is not to be construed as an offer or solicitation for the subscription, purchase or sale of any mutual fund. No investment decision should be taken without first viewing a mutual fund's offer document/scheme additional information/scheme information document. Any advice herein is made on a general basis and does not take into account the specific investment objectives of the specific person or group of persons. Investors should seek for professional investment, tax, and legal advice before making an investment or any other decision. Past performance and any forecast is not necessarily indicative of the future or likely performance of the mutual fund. The value of mutual funds and the income from them may fall as well as rise. Opinions expressed herein are subject to change without notice. Please read our disclaimer in the website.


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