How To Measure Mutual Fund Risk

Mutual fund often carry the line “past performance is not indicative of future returns”. We all know that investing in mutual funds purely on the basis of historical returns is risky. So how does one assess and compare between different schemes?
Fortunately there are standard indicators commonly used in the industry for evaluation. These indicators of risks can be readily applied to analysis of mutual fund schemes as they help us in evaluating the risk-reward parameters easily. Knowing these ratios is essential for any mutual fund advisor/distributor, even though it may not be a foolproof tool of arriving at investment decisions.
In this article, we will talk about these most popular and used indicators. We assume that you will not need to compute the ratios since such info is readily available in most publications /websites.

1. STANDARD DEVIATION (SD)

Definition:

• Statistically, standard deviation measures the dispersion of any data from its mean. In plain English, it means how much returns (read data) is spread apart from the mean or average returns.

Interpretation:

• SD indicates the volatility in returns based on historical data. Thus higher the SD, higher is the volatility in returns and thus higher is the risk.

• You should prefer funds with lower SD.

2. BETA

Definition:

• Beta measures a scheme's volatility compared to that of a benchmark /market. It tells you how much a fund's performance would swing compared to a benchmark.

• Beta, in other words, is a measure of systematic risk or the risk which is attributable to the entire market /benchmark, merely by being present in same.

Interpretation:

• Beta will show how much a scheme's performance is impacted by benchmark /market movement. If a fund has a beta of 1.5, it means that for every 10% upside or downside, the fund's NAV would likely be 15% in the respective direction.

• Whether a high or low beta is good actually depends on the state of the market. If the market is in a bull phase, a scheme with a higher beta will deliver greater returns while in a bearish market, a low beta scheme will be a better choice.

3. ALPHA:

Definition:

• Alpha is a measure of an investment's performance on a risk-adjusted basis. It is the excess return of the scheme relative to the return of the benchmark index.

• In plain English, it basically is the difference between the returns an investor expects from a fund, given its beta, and the return it actually produces.

Interpretation:

• Alpha is often considered to represent the value that a fund manager adds to or subtracts from a fund's return. In other words, Alpha is the return on an investment that is not a result of general movement in the benchmark /market.

• Alpha is reported as a number less than, equal to, or greater than 1.0. A positive Alpha means the scheme has outperformed its benchmark index and vice-versa. The higher a scheme's Alpha, the greater ability to profit from moves in the underlying benchmark.

4. R-SQUARED

Definition:

• R-Squared measures the relationship between a portfolio and its benchmark. It can be thought of as a percentage from 1 to 100.

• It is not a measure of performance and is simply a measure of correlation of a scheme's returns with it's benchmark returns.

Interpretation:

• Beta & R-Squared are related but different measures. R-Squared show shows closely is the scheme returns are correlated or attributable to the benchmark while Beta shows how much will the scheme returns move in reaction to movement in benchmark.

• R-Squared is useful to ascertain the importance of Alpha & Beta. If R-Squared is high, Beta becomes more significant and importance of Alpha reduces as the scheme is closely correlated/similar to the benchmark. If R-Squared is low, it indicates that the fund manager has made the scheme portfolio different than the benchmark and thus Alpha will be more significant and beta less important.

• If one desires a portfolio that is similar to a benchmark then you should choose a high R-Squared scheme and vice-versa. A hypothetical scheme with 0 R-Squared will have no correlation with benchmark while a scheme with 100 R-Squared will almost a replica of the benchmark. Index schemes will have a R-Squared very close to 100.

5. SHARPE RATIO (SR)

Definition:

• The Sharpe ratio is the average return earned in excess of the risk-free rate 'per unit' of volatility or total risk. In other words, it evaluates the return that a fund has generated relative to the risk (as measured by Standard Deviation) taken..

• Developed by William F. Sharpe, SR is today one of the most commonly used ratio for studying mutual funds performance.

Interpretation:

• This ratio helps us to know whether it is a safe to invest in a scheme by taking the risk present. The higher the SR, the better is a scheme's return relative to the amount of risk taken. In other words, the greater the SR, the better its risk-adjusted performance.

• Generally speaking, a scheme with a lower SR and a higher Standard Deviation (SD) should not be preferred. A scheme with higher SR and a lower SD is most preferred as it is giving more returns per unit of risk taken.

• The SR tells investors whether an investment's returns are due to smart investment decisions or the result of excess risk. It is more useful for schemes with lower correlation to the markets or lower R-Squared.

Important note while comparing schemes:

• Comparison between schemes should be made belonging to similar periods and to the same category or peer-set of schemes.

• Comparison should ideally be made in sufficiently long periods to avoid any distortions due to market movements in short term.

• A low R-squared or Beta does not necessarily make an investment a poor choice. It merely means that its performance is statistically unrelated to its benchmark.

Conclusion:

Evaluation of mutual funds go much beyond just scheme ratios and historical returns. There are other important factors to assess like AMC due diligence, fund manager due diligence, investment process & philosophy, investment team, infrastructure and so on. At NJ, we have an in-house research team that does consider all these factor before making any recommendations to its' Partners. While you can rely on such recommendations, it is also important that you be aware of the scheme ratios normally used in the industry. This basic knowledge is essential for any Partner who wishes to project himself as an expert to their investors.