2: The Majority of Stocks Underperformed CNX 500 Index
3: Mutual Funds Have Delivered Better Risk-Adjusted Returns
1: Use the fund selector function on our website to find Sharpe ratios
2: Select the sector
3: Information on Sharp Ratio can be found in the table.
- 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）
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）
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
Where can I find such
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
Ignore An Investment's Risk Level!
and Earnings Growth
|The Research Team is a part of
Financial Pvt Ltd.
and/or its content and research
team’s licensed representatives may own or have positions in
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
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without notice. Please read our disclaimer in the website.