In my several years of analyzing and writing on Nigerian mutual funds, many questions that I have been asked bothers mostly on mutual fund performances or returns. No one has ever asked me about mutual fund risks, as if the risk is not of any importance to them.
Risk is one of the things that should concern you as an investor. Risk is an ingredient of every type of investment. As an investor, you cannot totally run away from it but you can manage it through diversification, by selecting and mixing your portfolio up with assets of varying risks and correlations.
Risk management starts with an understanding of what risk is and how to measure it. It also needs an understanding and a self-analysis of an investor, with a view to knowing the investors’ risk tolerance or appetite.
Different investors have different appetite or tolerance for risk. The amount of risk each investor is willing to take in order to achieve a given return is his risk tolerance. Conservative investors opt for low-risk investments, the downside of which is that they have to live with low returns too, while aggressive investors go for high risk-high return investment types.
What is Risk?
According to the dictionary, “Risk is a situation involving exposure to danger or harm”. However, when the word risk is used with respect to mutual funds or stocks, it implies volatility.
Volatility on the other hand, is the fluctuations in the unit prices of mutual funds or stocks. The greater that volatility, the greater the risk. Mutual fund risks are indicated with historical volatility.
How do investors measure risk?
There are many measures of mutual fund risk, but the most basic is standard deviation. When standard deviation is calculated with respect to a mutual fund, it is calculated as a measure of the extent to which the actual performance of the mutual fund in question has deviated from the average performance.
How Mutual Fund Standard Deviation should be used
Investors use and should use standard deviation to rank mutual funds’ risk with a view to uncovering which fund aligns with the investor’s risk appetite and tolerance. Though mutual funds can be ranked in accordance with their risk as indicated by their standard deviations, there are other risk-adjusted measures that can help an investor to sift between mutual funds in the selection process.
Here are some of them:
- Sharpe Ratio: Sharpe ratio is a risk-adjusted statistic that tells an investor if the returns a mutual fund made over a period of time is commensurate with the risk exhibited by that mutual fund over the same time period. A fund with a higher Sharpe ratio should be more preferable to one with a lower Sharpe ratio.
- Alpha: It is another measure of mutual fund risk-adjusted performance. Alpha is a measure of the extent to which a mutual fund performs better than a given but suitable market index. Using the Nigeria All Share index as an example, a mutual fund with an Alpha measure of 1% implies that the fund outperformed the ASI by 1%. Alpha helps to know if a fund performance is due to manager’s asset allocation skills or due to luck. It is therefore a fund manager selection tool as well.
- Beta: Beta is a measure of the volatility of a mutual fund in relation to the volatility of a given but suitable market index. A higher beta indicates that the mutual fund has more volatility and therefore more risk than the index in question. Beta is calculated by conducting a regression analysis of mutual fund returns versus index returns over a period of time.
- R-Squared: It is a statistic that measures what percentage of movement in or returns from a mutual fund that can be attributed to movements in the overall market index. A fund with an R-Squared of .9 indicates a high correlation with the market and that 90% of the returns from the fund can be explained by events in the overall market. R-Squared therefore, helps to uncover how a fund manager’s asset allocation ability benefits a mutual fund. It could be useful in not only fund selection but also in manager selection.
I have intentionally belaboured you with all the above seemingly boring piece of this article, so you will understand the basis for my selection of the 5 low-risk mutual funds in Nigeria with positive Alpha. This analysis is based on the NAV Summary Report from January 2010 to November 6th 2020.
Here they are:
- Stanbic IBTC Bond Fund: This is currently the fund with the lowest risk. According to Quantitative Financial Analytics, Stanbic IBTC Bond fund has a standard deviation of 0.15, an Alpha of 2.09 and a Sharpe ratio of 4.15.
- Stanbic IBTC Absolute Fund: This is the second-lowest risk mutual fund in Nigeria. It has a standard deviation of 0.18, an Alpha of 1.81, and a Sharpe ratio of 2.83
- Legacy Short Maturity Fund: This is the third-lowest risk mutual fund in Nigeria. This fund has a standard deviation of 0.2, an Alpha of 2.08, and a Sharpe ratio of 2.78
- Stanbic IBTC Guaranteed Fund: This is the fourth-lowest risk mutual fund in Nigeria going by its standard deviation of 0.22, an Alpha of 2.96, and Sharpe ratio of 4.03
- Coral Income Fund: This is the fifth-lowest risk mutual fund in Nigeria as indicated by its standard deviation of 0.43, an Alpha of 0.38, and a Sharpe ratio of 0.25
Note that this ranking is solely driven by the standard deviation as a measure of risk. However, the ranking changes when done on a risk-adjusted basis of Sharpe Ratio. I will do a piece on risk-adjusted ranking in my next article.