It's said that the best way to lower the impact of market volatility on equity investments is to use the mutual fund route. Equity funds are diversified across multiple scrips and sectors. So the fall in any given scrip doesn't impact returns much.

But equity funds are not completely safe. The disclaimer "mutual funds are subject to market risk" is true even if you're sick of the ads. Of course, market meltdowns have a negative impact. Also, since May 2005, most funds have underperformed the Sensex, which returned 69 per cent between May 2005 and 19 May, 2006, while the average equity fund delivered a 64 per cent return.

Does that mean it's time to review your portfolio? Outlook Money did a comprehensive survey of the fund universe recently (India's BEST mutual funds, ranked!). But, given the recent meltdown, it is time to focus on those equity funds that appeared the least risky.

Methodology: How did we separate the wheat from the chaff? Every equity fund that has given a positive return in the last two years but many have under-performed the Sensex. In the past year, only 44 out of 108 funds beat the Sensex. In the last three months, as volatility increased, only 46 out of 138 funds beat the index.

We examined all diversified equity funds to see which funds beat the category average and the index while displaying minimal risk.

We considered only funds with three-year track records to measure long-term consistency. We examined three parameters -- the beta, pure returns and risk-adjusted returns (RAR).

A fund's beta ratio is a standard risk parameter. Beta measures movements relative to the index and thus, the relative riskiness of a fund compared to the market. The higher the beta, the more volatile the fund. Expressed as a single digit number, a beta of plus 1 means the fund is exactly as volatile as the market. (A negative beta indicates it moves in the opposite direction to the market).

If the fund's beta is 2, it moves twice as much as the market. That is, if the market moves up 10 per cent, a 2-beta fund moves up 20 per cent. A beta less than 1 means that the fund is less volatile. For example, a beta of 0.5 indicates that if the Sensex moves up 10 per cent, the fund moves up 5 per cent.

After calculating beta, we took the fund's rolling returns. To discover long-term consistency, we averaged out the day-to-day returns over the past three years. Finally, we divided the fund's beta (risk) from its rolling returns, to derive the risk-adjusted return (RAR).

These filters were used to cull out funds that scored good returns with the least volatility. Our cutoffs were (a) a beta lower than the category average (0.859); (b) higher returns than the average (64.65 per cent); and (c) a RAR higher than the category average (0.208).

Sundaram Select Mid-cap Fund emerged the topper on the basis of its highest RAR.

We applied an inverse set of filters to discover the most avoidable schemes. Here, we sorted funds on the basis of beta higher than the category average, and pure returns as well as RAR lower than the category average.

The most risky appears to be Taurus Discovery Stock.

The Winners

The Top 10 are familiar. Franklin India Prima topped Outlook Money's 2006 mutual funds rankings. SBI [Get Quote] Magnum Global Fund 94 was fifth. Nearly all the toppers displayed low volatilities despite being mid-cap funds. One possible reason: in the past three years, mid-caps have largely risen. It's only in the past six months that they've swung both ways.

Impeccable management is another reason for low volatility. Funds like Sundaram Select Mid-cap and Franklin India Prima have been consistent, proving they're not a flash in the pan. A sizeable corpus enables them to diversify and not be over-exposed to any given scrip. Franklin India Prima Fund's corpus is Rs 2,444.60 crore (Rs 24.446 billion); Sundaram Select Mid-cap has grown from Rs 241.53 crore (Rs 2.415 billion) in January 2005 to Rs 745.37 crore (Rs 7.453 billion) currently. While FT restricts the large-cap Franklin India Bluechip fund to 30 stocks, it holds 57 stocks in the mid-cap oriented Franklin India Prima.

Says fund manager, K N Sivasubramanian: "Given the liquidity and risk considerations of the small- and mid-cap segment and the size of the fund, we generally tend to take a smaller exposure over a large number of companies. We take a larger exposure to a few large companies with better liquidity and long-term fundamentals. The balance of our assets is spread across 30-35 small companies. We adopt a proactive approach and aggressively book profits as soon as our target prices are met."

The fund has stopped accepting fresh investments until August 2006.

Sundaram Select Mid-cap has a 92-scrip portfolio and a mandate not to invest over 4 per cent in any scrip. Compare it to Taurus Discovery Stock fund that has 51 per cent in its top three holdings and you see the difference. SBI Mutual Fund shares a similar philosophy of wide diversification and almost all its funds have done well.

A revamped fund management team and strict internal risk management controls are responsible for the SBI MF turnaround. SBI Magnum Global Fund '94 has tasted success with mid-cap stocks like Ansal Properties, Havell's India, Thermax, Hindustan Sanitaryware, Man Industries, among others. Regulars like HDFC Equity, Reliance Vision, SBI Magnum Contra and Franklin India Bluechip miss the top ten by a whisker.

These funds have a slightly higher beta. The first two are significantly invested in large-caps, while Franklin India Bluechip is strictly large-cap. Despite the higher volatility, these remain good, long-term investments.

The Also Rans

With a corpus (April 2006) of only Rs 25.6 crore (Rs 256 million), Taurus Discovery Stock is at the bottom of the stack. A huge 51 per cent is invested in the top three scrips. And this over-concentration is consistent across Taurus's funds. This fund has the highest beta, making it very risky. It's performance is also modest -- it has returned 31 per cent and 50 per cent in the past one and two years respectively, underperforming the category both times.

Among others in the losers list, LIC [Get Quote] MF Equity Fund was the worst performer in 2005. It returned 43 and 29 per cent in the past one and two years, respectively. These funds also suffer from a low corpus.

Five out of the 10 wooden spooners have a corpus of less than Rs 100 crore (Rs 1 billion). Escorts Growth Plan and ING Vysya Equity Fund hold Rs 5.7 crore (Rs 57 million) and Rs 8.2 crore (Rs 82 million) -- April 2006.

Small funds have several disadvantages. They can't invest heavily in mid-caps, so they missed out on the best performers of the bull-run. They also have to provision for redemptions and have relatively larger cash allocations. For instance, Escorts Growth Plan held 12-25 per cent in cash through most of 2005. High cash allocations also drag down performance.

Conclusion

Equity funds do rise and fall more sharply than other asset classes. But if you select a combination of low volatiliy and high-performance, you are most likely to win in the long run.

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