Contents
Introduction
Mutual funds are considered as a profitable investment option. Since there are different schemes available in the market, it can get confusing for the investors to make a choice. Based on the long-term financial goals and tenure, an investment option should be chosen. Mutual funds offer diversification of the mutual fund portfolio and carry a low risk with a high return probability. The Mutual fund risk ratio can help you to judge the worthiness of a fund.
Mutual Funds
A mutual fund is a financial model made up of a pool of money collected from many investors to invest in securities such as stocks, bonds, money market instruments, and other assets. Mutual funds are operated by professional money managers. They allocate the fund’s assets and attempt to produce capital gains for the fund’s investors.
A mutual fund’s portfolio is structured and is well maintained to match the investment objectives by the investors stated in its prospectus. Mutual funds help to give small or individual investors access to professionally managed portfolios of equities, bonds and other securities.
Mutual Fund Risk Ratio
The ratios are studied by fund managers to decide whether to invest or not. Investors need to understand the implication of the ratios before making an investment decision.
Here is a few mutual fund risk ratio that can help you judge the investment worthiness of the fund:
- Standard Deviation
- Beta
- Sharpe ratio
- Alpha
- R-Square
Standard Deviation
In Standard deviation, we get to know how far the returns are from their average. The more spread out the data, the greater the difference is from the average. In finance, the standard deviation is applied to the annual rate of return of an investment to measure its risk. The higher the risk of the fund the more the volatility of the stock and thus have a high standard deviation. With mutual funds, the standard deviation tells us how much the return on a fund is deviating from the expected returns based on its historical performance. According to the image 1 standard deviation has the highest return as compared to 2 standard deviations and 3 standard deviations.
Beta
The Beta, also known as the beta coefficient, is a measure of the volatility/ systematic risk, of a security/a portfolio, compared to the market as a whole. Beta is calculated using regression analysis and it represents the tendency of an investment’s return to respond to movements in the market. The market has a beta of 1.0.
A beta of 1.0 indicates that the investment’s price will move parallel with the market. A beta of less than 1.0 indicates that the investment will be less volatile than the market. Correspondingly, a beta of more than 1.0 indicates that the investment’s price will be more volatile than the market. For example, if a fund portfolio’s beta is 1.2, it is theoretically 20% more volatile than the market.
Investors who wish to preserve capital should focus on securities and MF portfolios with low betas while investors willing to take on more risk in search of higher returns should opt for high beta investments.
Beta coefficient(β)=Covariance(Re,Rm)/Variance(Rm)
where:
Re=the return on an individual stock
Rm=the return on the overall market
Covariance=how changes in a stock’s returns are related to changes in the market’s returns
Variance=how far the market’s data points spread out from their average value
Types of Beta
High β – A company with a β that’s greater than 1 is more volatile than the market. For example, a high-risk technology company with a β of 1.75 would have returned 175% of what the market return in a given period (typically measured weekly).
Low β – A company with a β that’s lower than 1 is less volatile than the whole market. As an example, consider an electric utility company with a β of 0.45, which would have returned only 45% of what the market returned in a given period.
Negative β – A company with a negative β is negatively correlated to the returns of the market. For example, a gold company with a β of -0.2, which would have returned -2% when the market was up 10%.
Sharpe Ratio
The Sharpe ratio was developed by Nobel laureate economist William Sharpe. The Sharpe ratio measures risk-adjusted-performance. Technically, the ratio is defined as the excess returns of a scheme (over a risk-free rate) divided by the standard deviation of the scheme’s returns for a given period. The Sharpe ratio tells investors whether an investment’s returns are due to wise investment decisions or the result of excess risk. The greater an investment’s Sharpe ratio, the better its risk-adjusted-performance.
A ratio of:
- 1 and above is good,
- 2 and above is very good and
- 3 and above is excellent
It is advisable to look at this ratio over several periods to assess how the scheme(s) has fared in different market cycles.
Example :
Scheme Y returns 10% in a year while Scheme Z returns 8%. If the risk-free rate is 4%, and the standard deviation of Y and Z is 8% and 4% respectively, thus their respective Sharpe Ratios are 0.75 and 1 by dividing the (10-4)/8 for scheme Y & (8-4)/4 for the scheme X. Thus, contrary to the initial inference that scheme Y was the superior performer (based on returns), scheme Z turns in a better performance on the risk-adjusted front.
Alpha
The alpha ratio gives you information about mutual fund performance as compared to the benchmark index. The alpha ratio measures the return and risk concerning the benchmark index. A high Alpha means the better performance of the fund.
Alpha Ratio takes the volatility of a security or fund portfolio and compares its risk-adjusted performance to a benchmark index. The excess return of the investment relative to the return of the benchmark index is its alpha. Simply stated, alpha is considered to represent the value that a portfolio manager adds or subtracts from a fund portfolio’s return. An alpha of fund 1.0 means the fund has outperformed its benchmark index by 1%. Similarly, an alpha of -1.0 would indicate an underperformance of 1%. For investors, the higher the alpha the better.
Alpha= R – Rf – beta (Rm-Rf)
Where:
R represents the portfolio return
Rf represents the risk-free rate of return
Beta represents the systemic risk of a portfolio.
Rm represents the market return
For example, the actual return of the fund is 30, the risk-free rate is 8%, beta is 1.1, and the benchmark index return is 20%, alpha is calculated as:
Alpha = (0.30-0.08) – 1.1 (0.20-0.08)
= 0. 088 or 8.8%
Thus the investment has outperformed the benchmark index by 8.8%.
R-squared
R-squared is a statistical measure that represents the percentage of a fund portfolio or a security’s movements that can be explained by movements in a benchmark index. For fixed-income securities and bond funds, the benchmark is the BSE Sensex, CNX Nifty.
R-squared values range from 0 to 100. A mutual fund with an R-squared value between 85 and 100 has a performance record that is closely correlated to the index. A fund rated 70 or less typically does not perform like the index.
R2= 1−Explained Variation/Total Variation
Conclusion
There are five main indicators of investment risk that apply to the analysis of stocks, bonds, and mutual fund portfolios. They are an alpha, beta, r-squared, standard deviation and the Sharpe ratio. These mutual fund risk ratio help an investor in deciding whether the plan they are selecting is profitable or not. While choosing mutual funds one should analyze the fund’s NAV, AUM, annualized returns, exit load, etc.
To make a successful investment in index funds, you can visit our website Wealthbucket. We offer various services like Equity Funds, Debt Funds, Balanced Funds or Income Funds. Moreover, you also give us a call at +91 8750005655, our experts are always present for the betterment of investors. Also, you can email at contact@wealthbucket.in.
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