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Measuring Mutual Fund Risk
Investors often tend to look at investments only from the perspective of generating maximum returns for the money they are investing. Often, with this viewpoint, they hardly look at their own risk profile and the risk of the investment before making a decision. Almost all investments come with a degree of risk. If your return on these investments is not proportional to the risk associated with it, then it may not be fruitful to make these investments.
A good mutual fund is the one that gives better returns in its category, given the same risk.
While returns can be easily tracked, how does one determine or measure the risk associated with mutual funds?
Fortunately, there are ratios that already exist and calculate the risk and volatility of any mutual fund portfolio. This will not only give you a better understanding of risk and volatility, but also help you choose a better fund when you are looking at various mutual fund offer documents. Let us take a look at some key tools or ratios that measure this risk.
Alpha gives a measure of the risk adjusted performance of your investment. Simply put, it will give you an idea of the excess returns that your invested fund may generate, compared to its benchmark. For example, if a mutual fund scheme has an alpha of 5.0, it usually means that the fund has outperformed its benchmark index by 5%. It can be seen as the additional value the mutual fund manager adds or takes away from the return on your portfolio. Alpha can be negative or positive.
Let’s say you invest in a mutual fund XYZ, having BSE Sensex as its benchmark. Let’s further assume that BSE Sensex that has given a return of 20% in a specific year. If the given value of alpha is positive 2.0, then it means that XYZ has outperformed its benchmark index by 2% and given 22% as returns for that specific year. Similarly, a negative alpha of 2.0 may mean that XYZ has underperformed compared to BSE Sensex and given 18% as returns for the specific year.
Beta denotes the sensitivity of the mutual fund towards market movements. It is the measure of the volatility of the mutual fund portfolio to the market. When you are looking at the beta of a mutual fund, you are finding out the tendency of your investment’s return to respond to the ups and downs in the market. Here, the market usually refers to the benchmark index the fund follows. The beta of the market or benchmark is always taken as 1. Any beta less than 1 denotes lower volatility and higher than 1 denotes more volatility compared to the benchmark index.
For example, if your mutual fund portfolio XYZ has a beta of 0.70, it denotes lower volatility. This means that for every rise or fall of 1 in the market, the value of XYZ may rise or fall by 0.70. If you have a low to medium risk profile, then you should look at funds having a lower beta value. Further, when looking at beta, it always preferable to also check how closely your mutual fund portfolio mirrors the benchmark.This correlation can also be seen by a ratio called R-Squared. R2 or R-Squared is a statistical measure that explains to what extent the portfolio movement mirrors the movement by the benchmark index. The values of R-Squared lie between 0-100. The value of R-Squared needs to be higher than 80 to indicate a high correlation of beta and the mutual fund portfolio. Beta may not be so effective in case your portfolio doesn’t closely follow the benchmark.
Standard Deviation
Standard deviation is a statistical tool that measures the deviation or dispersion of the data from the mean or average. When seen in mutual funds, it tells you how much the return from your mutual fund portfolio is straying from the expected return, based on the fund’s historical performance. For example if the portfolio XYZ has a standard deviation of 7% and average return of 15%, it means that it has a tendency of deviating by 7% from its expected average return and may give returns between 8% to 22%. Standard deviation is directly proportional to the volatility of the portfolio. It is also used in calculating Sharpe’s Ratio.
Sharpe’s Ratio
The Sharpe’s ratio uses standard deviation to measure a mutual fund’s risk adjusted returns. It will tell you how well your mutual fund portfolio has performed in excess of the risk-free return (if you would have invested in government securities instead, which are almost risk-free). This essentially gives you an idea if your returns are due to smart investment decisions or excessive risk. Higher the Sharpe’s ratio, better the risk adjusted return of your mutual fund portfolio.
You can combine the inferences from the above methods of measuring risk with information like the fund history, past performance and expense ratio to identify the best-suited mutual fund schemes for your portfolio and your risk profile.
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Since Sharpe’s ratio uses standard deviation, it can be used across all fund categories.
Aggressive investors can look at funds that have high alpha values to increase their potential of high returns.
These ratios, in isolation, can’t tell whether the fund is good or bad. It is only when you compare it to other funds in the same category, they will give you the best option available for investment.
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