Understanding mutual fund analysis can be a daunting task for investors, who may struggle to interpret the complex array of performance indicators and ratios. These ratio’s metrics not only help in evaluating a fund’s historical performance but also in making informed investment decisions by highlighting areas of strength and potential weaknesses. By analyzing these ratios, investors can better align their choices with their financial goals and risk tolerance, ensuring a more strategic and informed approach to investing in mutual funds.
This article will explore how these indicators can be useful for risk and return analysis using key metrics: Beta, Alpha, Sharpe Ratio, Standard deviation (SD) & Sortino ratio.
1. Beta
Beta in mutual funds is a metric that indicates the volatility of a fund relative to the overall market or a specific benchmark index. It’s a measure of the fund’s sensitivity to market movements:
– Beta of 1: If a mutual fund has a beta of 1, it implies that the fund’s value is expected to move in lockstep with the market. If the market goes up by a certain percentage, the fund is also expected to go up by roughly the same percentage, and vice versa.
– Beta Less Than 1: A beta less than 1 suggests that the fund is less volatile than the market. If the market experiences ups and downs, the fund’s value should fluctuate less. These funds are typically perceived as less risky.
– Beta Greater Than 1: Conversely, a beta greater than 1 indicates that the fund is more volatile than the market. If the market swings, the fund’s value is likely to swing even more.
Beta Calculation
Beta = (Fund return – Risk-free rate) ÷ (Benchmark return – Risk-free rate).
Fund A | Fund B | |
Fund Return | 67 | 54 |
Risk Free Rate | 5 | 5 |
Benchmark Return | 54 | 60 |
1.27 | 0.89 |
From the Above table we can see that the Fund B beta is less than 1 which means the fund B is less volatile than the market. Whereas Fund A has the beta more than 1 which is more volatile & if the markets fluctuate more this fund will also remain volatile. This can mean higher risk but also the potential for higher returns.
2. Alpha
Alpha is a parameter to evaluate the performance of the asset manager for his/her efforts in driving the fund to return profits as compared to a benchmark index. A benchmark index is set against which the performance of the fund is measured in terms of alpha.
– If the value of alpha is greater than 0, it means that the fund is performing better than the benchmark index.
– In case the value is less than 0, it means that the fund is underperforming when compared to the benchmark index.
– If the value is equal to 0, it means that the fund is performing exactly the same as the benchmark index.
Let’s take the Example
Mutual Fund Scheme | ||
Fund A | Fund B | |
Alpha Ratio | 4 | -2 |
1 Yr. Benchmark return | 25% | 25% |
Return | 29% | 23% |
Suppose you invest in a Mutual Fund A, and its benchmark is NIFTY. Let’s assume the return from NIFTY has been 25% in a year. And the Alpha of your fund is 4. This indicates that mutual fund A has outperformed the benchmark by 4%. The return from the fund is 29% for the same year. Similarly, if the fund’s alpha is -2, it means that the fund has underperformed its benchmark by 2%, and the returns from the scheme are 23%.
3. Sharpe Ratio
Sharpe Ratio of a mutual fund reveals its potential risk-adjusted returns. The risk-adjusted returns are the returns earned by an investment over the returns generated by any risk-free asset. However, higher returns indicate extra risk. Higher Sharpe Ratio means greater returns from an investment but with a higher risk level. Therefore, it justifies the underlying volatility of the funds. The investors aiming for higher returns will have to invest in funds with higher risk factors. The Sharpe ratio gives the return delivered by a fund per unit of risk taken. Therefore, an investment with a higher Sharpe Ratio means greater returns.
Mathematically, you can arrive at the Sharpe ratio by calculating the difference between the return of the fund and the return that you can earn from a risk-free investment, divided by the fund’s standard deviation.
Sharpe Ratio | Risk Rate | Verdict |
Less than 1.00 | Very Low | Poor |
1.00 – 1.99 | High | Good |
2.00 – 2.99 | High | Great |
3.00 or above | High | Excellent |
The table shows the features or parameters of a good Sharpe Ratio. Funds with less than 1.00 Sharpe Ratio do not generate high returns. Contrarily, investments with a Sharpe Ratio of 1.00 to 3.00 or above have higher returns subsequently.
4. Standard Deviation
In the context of mutual funds, the standard deviation is a measure of the fund’s volatility or risk. It quantifies how much the returns of the fund deviate from the average return over a specific period.
Here’s how to interpret it:
– Higher Standard Deviation: If a mutual fund has a high standard deviation, it means that the fund’s returns are more spread out from the average return. This indicates higher volatility, suggesting that the fund’s returns can vary significantly from the average, both positively and negatively. High volatility can be associated with higher risk.
– Lower Standard Deviation: Conversely, a low standard deviation indicates that the fund’s returns are more closely clustered around the average return. This implies lower volatility and, therefore, lower risk, as the returns are more stable and predictable.
5. Sortino Ratio
The Sortino ratio in mutual fund is a statistical tool that is useful to measure the performance of the fund with respect to the downward deviation. In other words, this ratio is used to determine the risk-adjusted returns of a particular investment scheme.
This ratio is a variation of the Sharpe ratio, but it considers the downside or negative return. Also, this ratio is helpful for investors to assess the risk in a better way rather than just looking at the returns to the total volatility. Since investors are more concerned about the downward volatility, the Sortino ratio gives an accurate picture of the fund’s performance after the potential risks have been adjusted.
Calculating Sortino Ratio.
Sortino Ratio = (R – Rf)/SD
Were,
R – Expected investment returns
Rf – Risk free rate of return
SD – Standard deviation of negative asset return
Fund A | Fund B | |
Expected Returns | 10% | 15% |
Risk Free Rate | 6% | 6% |
Downside Deviation | 4% | 12% |
Sortino ratio | (10%-6%)/4% = 1 | (15%-6%)/12 = 0.75 |
Typically, a higher Sortino ratio is better for mutual funds. In the above scenario, Fund A indicates it is generating more returns per unit of a given risk and has greater chances of avoiding losses.
Conclusion
Understanding these key ratios can help investors make informed decisions when selecting mutual funds. Each ratio provides a different perspective on the fund’s performance, risk, and operational efficiency, allowing investors to tailor their choices to their individual financial goals and risk tolerance. By analyzing the Standard deviation, Sharpe ratio, Beta, Alpha, and Sortino investors can gain a comprehensive understanding of how well a mutual fund is managed and how it might perform in various market conditions.
To understand more on the topic as well as to start investments please feel free to contact us:
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The article is authored by Mr. Kaustubh Parmar and Mr. Saurabh Gosavi from Team RichVik.