To many people, Mutual Funds can seem complicated or intimidating. A mutual fund is essentially the money pooled in by a large number of people or investors that is managed by a professional fund manager. It is a trust that collects money from a number of investors who share a common investment objective. Then, it invests the money in equities, bonds, money market instruments and/or other securities. Each investor owns units, which represent a portion of the holdings of the fund. The income/gains generated from this collective investment is distributed proportionately amongst the investors after deducting certain expenses, by calculating a scheme’s “Net Asset Value or NAV.
Today there are multiple ways an investor can analyse mutual funds. However, it is a fact that even the best performing mutual funds change from time to time. This often questions investors’ existing method to research and select a good fund.
Measuring Mutual Fund Risk via Ratios
There are five key indicators of investment risk that apply to the analysis of any mutual fund portfolio. These include alpha, beta, r-squared, standard deviation and the Sharpe ratio. All of these risk measurement ratios are intended to help investors determine the risk-reward parameters of their investments. Here is a brief explanation of each of these common indicators.
Beta - Beta is a measure of mutual fund schemes volatility compared to its benchmark. This ratio would help us to judge how much a fund’s performance can move upside/downside compared to its benchmark.
Beta = (Standard deviation of mutual fund scheme/Standard Deviation of Benchmark)* R-Square
Importance of Beta - A fund with beta value more than 1 would move more volatile than the market. i.e. if the market moves up 100% a fund with beta value of 1.5 would move up by 150% and if the market comes down by 20% the fund will come down by 30%. If beta value is less than 1 it means the fund will be less volatile than the benchmark. i.e. if the market moves up 100% a fund with beta value of 0.75 would move up by 75% and if the market comes down by 20% the fund will come down by 15%.
Alpha - Alpha is a measure of mutual funds’ performance after adjusting the risk. This ratio helps to measure the fund manager performance.
Alpha = Mutual fund scheme return – (Risk-free rate of return + (beta*(Benchmark return – Risk-free rate of return)
Importance of Alpha - Higher the alpha, it’s better for the investor. Positive alpha numbers indicate positive returns compared to the benchmark and negative alpha value indicates negative returns to benchmark. For example, if alpha is 8 it means scheme would outperform the benchmark by 8% and if alpha -8 the scheme will underperform by 8% compared to the benchmark.
R Squared - It’s a measure of co-relation between mutual fund schemes performance and its benchmark. It ranges between 1 and 100.
R – Squared = (covariance between the benchmark and mutual fund scheme/ (Standard deviation of the mutual fund scheme* standard deviation of the benchmark)) 2
Importance of R-Squared - A high R-squared, between 85% and 100%, indicates the fund’s performance patterns have been in line with the index. A fund with a low R-squared, at 70% or less, indicates the security does not act much like the index.
Standard deviation - Standard deviation (SD) measures the volatility the fund’s returns in relation to its average returns. It tells you how much the fund’s return can deviate from the historical mean return of the scheme. If a fund has a 10% average rate of return and a standard deviation of 4%, its return will range from 6%-14%.
The formula for data >3 yrs - Variance = (Sum of the squared difference between each monthly return and its mean/number of monthly return data)
The formula for data<3 yrs - Variance = (Sum of the squared difference between each monthly return and its mean/number of monthly return data – 1)
Standard deviation = square root of the variance
Importance of Standard Deviation - The higher the standard deviation, the more volatile is the fund’s returns. Prefer funds with lower volatility.
Sharpe Ratio - Sharpe ratio helps the investor tell if a mutual fund delivers the returns with respect to the risk taken by it on comparing a fund with a risk free rate of return.
Sharpe ratio= (Mutual fund returns – Risk-free rate of return)/ Standard deviation of mutual fund
Importance of Sharpe Ratio - Higher the better, if this value is negative it should be understood as mutual fund underperforms when compared to the risk-free rate of return (Govt. bonds or even a simple FD).
Importance of Mutual Fund Fact Sheet
A mutual fund fact sheet contains a plethora of information one should look into and consider before investing. This information pertains to the following aspects of the mutual funds:
Basic Information - This provides general information about the fund such as its objective, options, plan, net asset value, the minimum amount to be invested and data related to assets managed. Suitability of a particular product is highlighted by the fund's ‘product labelling’ and risk associated with a particular fund is given by ‘riskometer’.
Performance details - By providing the funds’ historical performance data, a clear picture is obtained of how the fund has fared in the market across time frames. This can be further compared to the individual fund’s benchmark and the market benchmark. These may include the graphical representation of the annual performances along with prescribed performance tables.
Information about Fund Managers - A fund manager’s expertise in the handling of portfolios is a very decisive factor in the effective managing of the investment. A fund manager’s experience and qualifications are available in the factsheet for investors to know then better. Their performance in handling portfolios across time is listed alongside.
Investing in mutual funds could be challenging especially since it involves an analysis of numerous qualitative and quantitative factors across different time intervals. An investor needs to keep his financial goals, risk appetite and investment horizon in mind while investing in mutual funds. A basic understanding of mutual fund ratios can prove to be helpful in keeping a check on the investment.