How to gauge the risks of the funds you put your money in

But given the number of articles in recent weeks, I would have to excuse myself from adding yet another view on something that involves only interpretations of the small facts we see.

I believe it would be more fruitful to understand the risk factors affecting your investment rather than speculate on how those factors are going to end up.

There are many angles from which you can view the risk of your investment, but for the con-text of this article, we shall focus on the quantifiable ones that should be readily available from any asset-management firm.

The most basic risk factor to be aware of in any investment is systematic risk, or the risk that cannot be diversified away. A good example would be reces-sion risk or the political risk that is always associated with an investment.

Moving on to something more quantifiable, the basic concept of risk measurement is just the use of one of the two basic sta-tistical concepts: standard devi-ation and correlation.

For a sin-gle asset with historical prices, standard deviation of historical returns is simply a measure of volatility, or the deviation from the mean. For a portfolio with multiple assets, the correlation among each asset is also taken into con-sideration when calculat-ing the portfolio standard devi-ation.

A typical fixed-income fund may have standard deviation of returns ranging from 0.2-1.5 per cent, while a typical equity fund may have standard deviation ranging from 10-25 per cent. This explains why equity is a riskier asset class than fixed income, because the volatility is higher.

A lot of the time, standard deviation alone is insufficient to define the risk of the funds.

The most sought-after answer for any investor, I believe, is to the question, "How will my fund per-form one year from now relative to the benchmark?" Unfortunately, we cannot foresee the future, but we can certainly quantify the benchmark risk, or the risk of the fund deviating from the benchmark - known as tracking error.

Tracking error, in its simplest form, is defined as the standard deviation of excess return over the benchmark.

A fund with, say 10-per-cent ex-ante tracking error means the expected return is expected to fall in the range of -10 per cent to +10 per cent rel-ative to the benchmark at a 68-per-cent confidence level.

However, this is a normal distri-bution assumption, meaning the fund has an equal chance of out-performing or under-performing the benchmark by 10 per cent. Also note that when asking for tracking-error numbers, be sure it is ex-ante - or the forward-looking number - not the ex-post historical numbers.

The equity funds we are man-aging have an ex-ante tracking error ranging from 6-16 per cent, which is considered high by all standards. We certainly do expect the deviation will be on the positive side, so that the fund outperforms the bench-mark and hence generates "alpha".

THALIT CHOKTIPPATTANA is an equity-fund manager at Ayudhya Fund Management.