Return, Risk & Performance of Funds

Ten per cent of the paper, and the unit that decides whether a distributor can read a factsheet properly. Most of it is arithmetic with a purpose: each measure exists because a simpler one was misleading in some specific way.

How should a return be measured?

An absolute return is simply how much the value grew, as a percentage. It is honest as far as it goes, and it goes only as far as one period — a 40% absolute return means something quite different over two years than over seven, and quoted without the period it is close to meaningless.

CAGR fixes that by restating the growth as a constant annual rate. Two holdings of unequal length become comparable, which is the whole point. It does not adjust for risk and it is not a promise about the future; it is a way of describing what happened.

For an SIP, neither will do. Each instalment went in on a different date and has been invested for a different length of time, so there is no single period to annualise. XIRR handles exactly this: it finds the rate that reconciles a series of cash flows on their own dates with the final value. If a question involves regular instalments, XIRR is almost always the answer it wants.

What does risk mean in numbers?

Risk in this syllabus mostly means variability — how much the returns move about, not merely whether they were positive.

• Standard deviation measures how widely returns have varied around their average. It captures total volatility, whatever the cause.
• Beta measures how much a scheme moves relative to its market. Above one means it has tended to move more than the market, below one less.
• Sharpe ratio is the return earned above the risk-free rate, divided by standard deviation — return per unit of risk taken.
• Alpha is the return over and above what the scheme's risk exposure would have predicted.

The distinction worth holding is between standard deviation and beta. One asks how much a fund bounces around; the other asks how much of that bouncing is the market's doing. A fund can be volatile with a low beta, if what moves it is not what moves the index.

Why a benchmark matters

A return on its own cannot be judged. Twelve per cent is excellent if the relevant index did six, and poor if it did eighteen. The benchmark is what converts a number into information, which is why every scheme names one in its offer document and reports against it.

The benchmark also has to be the right one. Comparing a small-cap scheme with a large-cap index tells you about the difference between small and large companies, not about the fund manager. Like for like is the whole condition.

Past performance, and what it is not

Every scheme communication carries the line that past performance may or may not be sustained in future, and it is not a formality. Returns are the outcome of conditions that do not repeat, and a period that flattered a strategy can end without warning.

This is also a compliance point rather than only a conceptual one: a distributor may not present past returns as an indication of future returns, and may not guarantee anything. Several questions in this unit are that principle wearing a different hat.

What the examination tends to ask here

About ten questions. Reliably: which measure suits which situation — absolute for one period, CAGR for comparing periods, XIRR for instalments — what each risk statistic describes, and why a benchmark and a period must accompany any return quoted to an investor.