How to use the ratio in Mutual Funds?
You may have heard famous sportspersons encouraging you to invest in mutual funds. Just like everything else, it is always better to assess the risk-reward equation before putting your money on the line. In this article, we will talk about certain ratios that help you assess mutual fund schemes.
People usually start investing in mutual funds just by looking at the past performance of the scheme they happen to be considering. But they hardly ever consider the risk posed by the investments they are undertaking and even their own risk profile.
It is of paramount importance that investors get acquainted with the factors surrounding a mutual fund so as to make better decisions while considering the risk which they can digest in accordance with their financial goals and investment horizons.
But how does one measure the risk associated with mutual funds? There exist certain ratios which quantify the risks and returns associated with mutual funds.
Let’s go through a few ratios one by one.
Firstly, we will cover standard deviation and the Sharpe ratio, then we will talk about Beta and the Treynor ratio. We will then discuss about the Sortino ratio and how it is different from Sharpe ratio, and then we will come to Alpha.
Let’s begin with Standard deviation
The standard deviation tells an investor how volatile the fund is by measuring the amount by which the fund’s returns deviate as compared to its average returns over a period of time. Standard Deviation measures the total risk of a fund.
A higher standard deviation implies higher volatility in returns. As an example, a fund having standard deviation of 7% implies that it has a tendency to deviate by 7% from its average returns. Funds with higher standard deviation are inherently riskier than their counterparts having lower standard deviation, so risk-averse investors should prefer funds having lower standard deviation. But only measuring the risk is not sufficient to choose the fund; you need to focus on the risk-return ratio.
Let’s define the Sharpe ratio to measure the risk-return ratio of a fund
The Sharpe ratio tells an investor whether a mutual fund generates the returns compared to the risk it carries. A higher Sharpe ratio indicates better returns in comparison to the risk taken by a fund. Sharpe ratio should not be seen in isolation as it should be compared with similar funds. A higher Sharpe ratio is considered better for a fund.
The Sharpe ratio is calculated by dividing the excess returns of a mutual fund scheme over a risk-free rate by the standard deviation of the returns delivered by the fund over a specific period of time.
Let’s now talk about Beta
Beta is a measure of the volatility of the mutual fund scheme in response to market fluctuations as compared to its benchmark. A beta of 1 implies an equivalent shift in the prices as compared to the benchmark movement, a positive beta of more than 1 implies a greater shift in the fund’s prices or NAV as compared to the benchmark index and a negative beta implies the opposite movement in the fund’s NAV. This price shift is a response to the volatility in the market.
Investors who are risk averse would choose a fund with beta in between 0 to 1 as it shows that the funds prices aren’t that severely impacted by volatility and those wanting more returns can choose funds with a beta of greater than 1 at the expense of more risk.
Let’s now deal with the Treynor ratio
Treynor ratio, just like the Sharpe ratio measures the risk-adjusted returns of a portfolio, with the difference being in how its calculated. Treynor ratio is calculated by dividing the excess returns of a mutual fund scheme over a risk-free rate of return by the Beta of the scheme instead of the standard deviation. The Treynor ratio only considers market risk instead of the total risk of a portfolio. Therefore, this ratio is more suitable for a diversified fund that carries primarily market risk.
Let’s come to the Sortino ratio
The Sortino ratio quantifies the performance of an investment in accordance to the downside risk, unlike the Sharpe ratio which considers both upside and downside risk.
As the Sortino ratio gives an idea about the negative deviation of a portfolio’s returns from the mean, the Sortino ratio is thought to provide a better view of the portfolio’s risk-adjusted performance as positive volatility is beneficial.
Funds with a higher Sortino ratio indicates that the fund is generating more returns per unit of the bad risk it takes on.
Additional Read: What are tax saving mutual funds and how do they work?
Let’s now talk about Alpha
Alpha represents the fund manager's performance to bring profits as compared to the risk taken. An alpha of zero implies that the fund manager did not add any value and returns are at par with a fund's risk. A negative alpha suggests the poor performance of a fund compared to the risk it carries. A positive alpha is considered better for a fund and signifies higher returns compared to the risk taken by a fund.
Investors should select mutual funds with a higher positive alpha when comparing similar funds.
Concludingly, to better analyse mutual funds for the outlook on the returns delivered by them and the risks associated with them, all these ratios which we walked through need to be used in combination to make effective decisions.
Additional Read: 7 reasons to invest in mutual funds
Let’s summarize everything we discussed:
- Standard deviation measures the deviation in the fund’s returns compared to its average returns spread across a period. Funds with higher standard deviation are considered riskier and vice-versa.
- Sharpe ratio addresses the risk-adjusted returns delivered by a fund. A higher Sharpe ratio translates to higher returns compared to the risk taken by a fund.
- Beta measures the volatility of the fund due to market fluctuations as compared to its benchmark. A positive beta less than 1 indicates low risk and greater than 1 signifies higher risk than its benchmark.
- Treynor ratio, just like the Sharpe ratio, addresses the risk-adjusted returns delivered by a fund but considers only market risk.
- Sortino ratio measures the performance of the investment in accordance with the downside risk. It is different from Sharpe ratio which considers both upside and downside risk. The Sortino ratio should preferably be high.
- Alpha is the measure of the fund manager’s performance and should preferably be positive.
Disclaimer: ICICI Securities Ltd. (I-Sec). Registered office of I-Sec is at ICICI Securities Ltd. - ICICI Venture House, Appasaheb Marathe Marg, Prabhadevi, Mumbai - 400 025, India, Tel No : 022 - 6807 7100. AMFI Regn. No.: ARN-0845. We are distributors for Mutual funds. Mutual Fund Investments are subject to market risks, read all scheme related documents carefully. The contents herein above shall not be considered as an invitation or persuasion to trade or invest. I-Sec and affiliates accept no liabilities for any loss or damage of any kind arising out of any actions taken in reliance thereon. Please note, Mutual Funds related services are not Exchange traded products and I-Sec is just acting as distributor to solicit these products. All disputes with respect to the distribution activity, would not have access to Exchange investor redressal forum or Arbitration mechanism. The contents herein above are solely for informational purpose and may not be used or considered as an offer document or solicitation of offer to buy or sell or subscribe for securities or other financial instruments or any other product. The contents herein mentioned are solely for informational and educational purpose.