Every Investor aspires to have best mutual fund in his/her portfolio but one cannot pick the winner without knowing the risk associated with it. There are many websites and advertisements which shows tempting yearly returns and rankings of mutual fund schemes to draw investors? attention, but choosing mutual fund blindly on the basis of historical data is bit risky. Investors need to evaluate the risk associated with the mutual fund in a regular interval, at least once a year.
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Investors may use the given below 5 ways to measure mutual fund risk:
1. Standard Deviation
Standard deviation is the most popular way of measuring mutual fund risk. It measures the volatility/deviancy of return of mutual fund scheme from its expected return based on the historical performance over a specific time period. For instance if a fund shows average return of 15% and a standard deviation of 5%, than its return can disperse within the range of 10% to 20%.
Higher Standard Deviation indicates that the NAV of mutual fund more likely to move and bears high risk in compare to fund with lower Standard Deviation.
Let us look at an example,
|Fund Name||1-yr Returns (%)||SD (%)|
|Mutual Fund A||19||18|
|Mutual Fund B||19||20|
Both the above funds are giving the similar return of 19% in one year. But what makes Fund A healthier is the Standard Deviation of 18%, marking Fund A less volatile or less risky as compared to Fund B having Standard Deviation of 20%.
Always remember Standard Deviation should be used to compare mutual fund with its peer group mutual funds only. This means that a mid-cap mutual fund should be compared with the mid-cap mutual fund with the same investment objective.
2. Sharpe Ratio
Sharpe Ratio, one of the widely used methods of tracking performance of mutual fund, was developed by Nobel laureate economist William Sharpe.
Sharpe Ratio evaluates the return that fund has generated vis-?-vis the risk taken by it. It is risk adjusted measure of return which helps to compare the performance of one fund to that of another fund.
Risk here is measured by Standard Deviation.
Share Ratio = (Rp-Rf)/SD(p)
- P = Mutual Fund
- Rp = Return of the fund
- Rf =Risk Free Return
- SD(p) = Standard Deviation of Fund
For instance, fund manager A generates a return of 15% while fund manager B able to post return of 12%, it is clearly evident the fund manager A is the better performer. But if the risk free rate of return is 5% and fund manager A took higher risk (SD of 8%) and fund manager B took lesser risk (SD of 5%).
The Sharpe Ratio of Fund Manger A would be 1.25 while Sharpe ratio of fund manager B would be 1.4, which is better than A. Based on Sharpe ration fund manage is the winner.
Higher the Sharpe Ratio, better the mutual fund is because it implies that the fund has generated higher returns in proportion to the risk taken by it. On the contrary, a negative Sharpe ratio indicates that the mutual fund in consideration is worth leaving.
Further, similar to Standard Deviation, comparison should be made with the peer group mutual funds for accurate evaluation.
3. Alpha (?)
Alpha of mutual fund simply means the excess return of the fund as compared to its benchmark index. If a fund shows a positive alpha of 15%, it would simply mean that fund has outshined its benchmark by 15% during a specific time period and if it shows a negative alpha of 10% means fund has underperformed by 10%.
Alpha of a fund is calculated on the yearly value i.e. the basis of computing Alpha is one year return of fund and its benchmark.
Formula of Calculating Alpha of Mutual Fund
? = Rp ? [Rf + (Rm ? Rf) ?]
- ? = Alpha
- Rp = Realized return of fund
- Rm = Market return
- Rf = risk-free rate
- ? = Beta
Say, Fund ABC has given 25% return (Rp) in last year having a Beta (?) of 0.69. The market return (Rm) (benchmark index) remained at 18% and risk free rate (Rf) hovered at 8%. So the Alpha of the fund ABD would be:
Alpha = 25- [8+(18-8)*0.69] = 10.1%
Alpha of 10.1% means fund ABC has outperformed the expected return by 10.1%.
For Investors, higher the positive alpha is, better the mutual fund scheme is.
4. Beta (?)
While Calculating the Alpha of Fund ABC we had taken ? of .69, but what actually Beta (?) denotes?
Beta measures the sensitivity of the mutual fund scheme towards the market movement. Beta is always benchmarked to 1. This means if Beta of a Fund is .80, the fund is less volatile as compared to market movement and if it is greater than 1 say 1.20 than the fund would be tagged as highly volatile as compared to market movement. For better understanding, if market goes up by 5%, then the NAV of fund with Beta .80 would move down by 4% and the fund with beta 1.20 would go up by 6%.
The minimum correlation between the mutual fund and the market movement should be at least 0.70 (70%), if the figure goes down from 0.70 than beta losses its significance. This correlation can be checked by using R-Squared Ratio. Thus higher the correlation of mutual fund with the benchmark, better the relevancy of the Beta.
Now the question arise that what would be good high beta or low beta? The answer to this question totally depends upon the state of the market. If the market sentiments are bullish, then a high beta fund would be good and in case of bearish market sentiments, the low beta fund would be your lifesaver.
As stated above, there should be a significant correlation between the beta of the fund and benchmark index. This Significance of the Beta is calculated by using R-Squared method.
R-Squared values range from 0 to 1. A mutual fund with an R-Squared value lies between 0.85 to 1 indicates a close correlation between mutual fund and the benchmark index. Value below 0.70 indicates a futility of beta and the fund return in this case would not be similar to their benchmark index. So lower the R-Squared figure, lesser the reliability of Beta and vice-versa.
|Standard Deviation||Lower the Standard Deviation, better the mutual fund is.|
|Beta||Go for higher beta funds if you are Bullish and go in for a low beta fund if you are bearish.|
|Sharpe Ratio||? Consistent Performer -> Low SD; High SR -> Higher ranked fund? Volatile Performer -> High SD; Low SR ?> Lower ranked fund|
|Alpha||Higher the Alpha, better the mutual fund performance is.|