Returns in mutual funds

The primary objective of investing in mutual funds is to get returns. Mutual fund returns can be in two forms – income and capital appreciation. It is also important to understand that mutual funds are market linked investments. Hence they are subject to certain risks. In this two part article, we will discuss measures of returns and risk in mutual funds.

Mutual fund returns

Why do we invest? We invest because we want our money to grow. This is known as capital appreciation. Another reason to invest is, getting income from our investment in form of dividend or interest payments. Both dividends and capital appreciation are part of mutual fund returns. Here are different measures of mutual fund returns:-

• Absolute returns: Absolute return is the growth in your investment expressed in percentage terms. For example, you invest Rs 1 lakh in a mutual fund scheme. After 5 years, the value of the units of your scheme is Rs 1.5 lakhs. The absolute return of your scheme is 50%. Absolute return is simple to understand and over the total investment horizon (investment to redemption), is tied to your goal. However, absolute return has one weakness – it ignores the time horizon.
• Annualized returns (CAGR returns): Annualized return, as the name suggests, measures how much your investment grew in value on a yearly basis after factoring in compounding. That is why it also called CAGR (compounded annual growth rate return). Compounding is, very simply, profits made on profits. If you invested Rs 1 Lakh in a mutual fund scheme and the value of your investment after 3 years is Rs 1.4 Lakhs, then annualized returns will be 11.9%. Notice that annualized return of 11.9% is less than the absolute return (40%) divided by the investment period (3 years); this is due to compounding effect. 
• Trailing returns: Trailing return is the annualized return over a certain trailing period ending on particular day e.g. today, end of previous month, end of previous quarter etc. Let us understand this with the help of an example - Suppose the NAV of a scheme today (March 10, 2017) is Rs 100. 3 years back (i.e. March 10, 2014), the NAV of the scheme was Rs 60. The 3 year trailing return of the fund is 18.6%. Suppose the NAV of the scheme 5 years back (i.e. March 10, 2012) was Rs 50. The 5 year trailing return of the fund is 14.9%.
• Price returns: Price returns measures the price appreciation of your mutual fund Net Asset Value (NAV) on an annualized (CAGR) basis. Suppose, the NAV of your scheme is Rs 100. Let us assume that one year later, the NAV is Rs 110. The price return will be 10%.
• Total returns: One weakness of price returns is that it only focuses on price and ignores cash-flows e.g. dividends. This weakness is resolved in total return which is the actual return including both capital gains and dividends. Let us understand this with an example - Let us assume, purchase NAV of your scheme is Rs 20. After 1 year, the purchase NAV is Rs 22. The price return is 10%. However, during the year the scheme also paid Rs 1 / unit as dividend. The total return of the scheme will be 15%.

Risks in mutual funds

While discussing measures of returns and risk in mutual funds, we discussed returns in mutual funds. Let us now discuss risks in mutual funds.

It must be understood that mutual funds do not give assured or fixed rate of returns. There is also no guarantee of capital protection in mutual funds. In this article, we will discuss the different types of risks, which mutual funds are subject to:-

• Market risk: This is the risk which affects the entire stock market. It can be caused by events which may affect the entire economy e.g. investment cycles, Government policies, RBI actions, global events e.g. COVID-19 pandemic, Global Financial Crisis, 9/11 terrorist attack in New York etc.
• Unsystematic risk: This is the risk which impacts only a particular stock or sector. Mutual funds aim to diversify unsystematic risk, but there may still be some unsystematic risk depending on the calls taken by the fund manager or type of funds e.g. sector funds, focused funds etc.
• Liquidity risk: This can arise due to inability of the fund manager to sell the underlying securities of scheme when the need arises. If there are not sufficient buyers in the market, a fund manager may be unable to sell the securities. This risk can impact both equity and debt funds.
• Credit risk: This risk is caused by the failure of the issuer of debt or money market securities in making interest or principal payments on time. This risk impacts mostly debt funds.
• Interest rate risk: Bond prices are affected by interest rate changes. Bond prices go up when interest rate goes down and vice versa. Interest rates can change for a variety of reasons viz. RBI actions, higher Government borrowings, currency depreciation etc. Debt funds are impacted by interest rate risk. However, some types of debt mutual funds are more affected by interest rate risk than others.
• Concentration risk: Concentration risk is the opposite of diversification risk. If a mutual fund scheme invests a relatively large percentage of its assets in a few securities, then the underperformance of those few securities can have a significant impact on the scheme performance. Concentration risk can impact both equity and debt funds.
• Currency risk: This is the risk of your scheme performance being affected due to the foreign exchange rate changes. Currency risk primarily impact international funds or funds which have significant exposures to foreign securities. 

Investors should understand each of these risk factors before investing. The risk factors of each scheme are clearly explained in the scheme information document (SID). You should read the SID or consult with your financial advisor before investing. SEBI also requires mutual funds to label the risk categories of each scheme in the scheme Riskometer. As per SEBI’s latest guidelines on this matter, risk labelling needs to be done at a scheme level rather than at a category level. The new Riskometer has six risk profiles:-

• Low
• Moderately Low
• Moderate
• Moderately High
• High
• Very High

Investors should always refer to the scheme Riskometer before investing so that they can make informed investment decisions. You should consult with your financial advisor if you need help in understanding the Riskometer and how you use it to match a scheme to your risk appetite. Rolling returns:  All the different return types mentioned above are point to point returns (i.e. return for a particular investment period). A major weakness of point to point is that it is biased by the prevailing market conditions. Rolling return is the average or median annualized return for the selected investment tenure beginning at a given start date (e.g. scheme inception date) and advancing one day sequentially till the last available date. Rolling return is an unbiased measure of return, since it takes into account returns in different market conditions.