In Equity Research we usually confine our analysis with Fundamentals of the stocks. Either we go in for Valuation techniques or much higher technical viewpoints of the Portfolio Theory (Markowitz, 1952). But in a slightly new addition to finance, we have “Financial Engineers” who believe that statistical and mathematical inference make much more sense that analyzing technical. Following are some of the basic figure that Financial Engineers rely on while establishing relationships between stocks and comparing stock movements with respect to indices.
This quantity measures the variability or volatility of a stock or portfolio (an individual’s or a fund) in relation to its average or mean. When we consider stocks historical figures we usually calculate its mean to analyze an average return over the last decade or so. The returns deviate from the average by this figure on either side. For short term investors, a higher value of standard deviation can prove fatal as the stock can move either way.To Exemplifying the theory, I have taken two pure Equity funds:
1. L&T Midcap Fund (σ =2.21), Returns (12.79%) with equity holding of 94.49% – The standard deviation from the mean return showcase that returns might fall in the range 10.58-15%. For usual investments mutual funds are a bet for long term hence the volatility might not provide the pinch but in the case where short term investments in stocks are made this measure can be kept in mind.
2.ICICI Prudential Banking & Financial Services fund (σ =2.49), Returns (14.8%) with equity holding of 92.12% -- Here the average returns are better than L&T and revolve around the range of 12.31-17.29%. Hence the range has broadened in comparison portraying a highlighted volatility.
Both this fund has been on the market since 2004 and 2008 respectively and hence the availability of data supports our assumption.
- Sharpe Ratio (SR)
The measure formulates itself to and was introduced by William Sharpe who received the Nobel Price in Economics for his widely used CAPM (Capital Asset Pricing Model) theory. The ratio captures the fund performance in comparison to the risk being taken in the portfolio. Continuing the same scenario for the above two funds we have:
1.L&T Midcap Fund (SR =0.13)
2.ICICI Prudential Banking & Financial Services fund (SR =0.11)
Both the funds do not provide good figures for the ratio as higher the ‘SR’ better is the risk-adjusted performance of the fund. A ratio of more than 1 (>1) represents a higher return in comparison with the index. Here the funds are in accordance with the index and would provide similar returns. For analysis, if see the value for ‘DSP Blackrock 3Y Close Ended Fund’ the ‘SR=1.02’ which is >1. Hence the risk-return trade-off between the fund and index is more than 1 and provides a better return in accordance with the volatility involved.
- Treynor Ratio (TR)
For Sharpe, we use to measure risk-return of the portfolio with the standard deviation and here we take Beta of the portfolio (which reflects the systematic risk). The Treynor Ratio shows the extra actual returns comparing it with risk-free rate (Rf). The higher the Treynor Ratio if the fund the better is the comparative fund performance.
1.L&T Midcap Fund (TR =23.05), Index TR =13.04
2. ICICI Prudential Banking & Financial Services fund TR =23.05), Index TR=13.04
Since for the both the funds the value is way more than Index’s Treynor and co-incidentally the funds have equal TR we do not find an appropriate comparison between the two. But in context, if we seek the TR for DSP Black Rock 3Y Close Ended Fund it is 16.48. Hence in comparison, we have the above two funds as a better bet than DSP. Also since the Sharpe is much lower than DSP Fund they provide a much less volatility with way higher returns.
(Data Source:mutualfundindia.com)
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