Five ways to measure mutual fund risk

Five ways to measure mutual fund risk

As other investment avenues carry risk, even mutual funds carry risk while they endeavour to create wealth for you as investors in long run. Hence you should choose mutual funds based on the risk tolerance level and return expectations.  Mutual fund investors can get lured by the flashy numbers of dividend payouts in percentages announced by fund houses on a regular basis in newspapers, websites etc.

Investors may perform a small 5 – step exercise to evaluate riskiness of particular mutual fund scheme as described below: –

1) Alpha:

Alpha basically is the difference between the returns an investor expects from a fund, given its beta, and the return it produces.

Computation: Alpha = {(Fund return-Risk free return) – (Funds beta) *(Benchmark return- risk free return)}.

Example-1:

Fund return (Fund performance in last one year): 75%

Risk free return: 8%

Benchmark return (Sensex performance in last one year): 41%

Beta: 0.69

By computing with above formula, we will get alpha as 0.44 for this fund.

A positive alpha means the fund has outperformed its benchmark index. Whereas, a negative alpha indicates an underperformance of the fund. The more positive an alpha the healthier for investors.

Here, the fund has underperformed since an alpha we computed is less than beta. It mean’s fund has produced less returns considering the risks fund is taking while comparing it with actual return to the one predicted by beta.

Note: The ideal time period for analysing alpha and beta value is one year returns from their funds.

2) Beta:

Beta is a measure of the volatility of a particular fund in comparison to the market as a whole, that is, the extent to which the fund’s return is impacted by market factors. Beta is calculated using a statistical tool called ‘regression analysis. By definition, the market benchmark index of Sensex and Nifty has a beta of 1.0.

It may be challenging for investors to compute it for each mutual fund scheme. However, one need not worry.

Let us consider 3 possible scenarios in interpreting beta numbers:

[Sensex is assumed as benchmark index].

A beta of 1.0 indicates that the fund NAV will move in same direction as that of benchmark index. The fund will move up and down in tandem with the movement of the markets (as indicated by the benchmark)

A beta of less than 1.0 indicates that the fund NAV will be less volatile than the benchmark index.

A beta of more than 1.0 indicates that the investment will be more volatile than the benchmark index. It is an aggressive fund that will move up more than the benchmark, but the fall will also be steeper.

Note: Conservative investors should focus on mutual funds schemes with low beta. Aggressive investors can opt to invest in mutual fund schemes which have higher beta value for higher returns taking more risk.

3) R-Squared:

As discussed above, beta is dependent on correlation of a mutual fund scheme to its benchmark index. So, while considering the beta of any fund, an investor also needs to consider another statistic concept called ‘R-squared’ that measures the correlation between beta and its benchmark index. The beta of a fund has to be seen in conjunction with the R-squared for better understanding the risk of the fund.

‘R-squared’ values range between 0 and 1, where 0 represents no correlation and 1 represents full correlation. If a fund’s beta has an R-squared value that is between 0.75 and 1, the beta of that fund should be trusted. On the other hand, an R-squared value that is less than 0.75 than it indicates the beta is not particularly useful because the fund is being compared against an inappropriate benchmark index. This fund will not give returns similar to their benchmark index. The lower the R-squared the less reliable is the beta, and vice versa.

The R-squared of an index fund, investing in same securities and in the same weightage as the index, will be one.

Note: Beta and R-squared are calculated based on the historical data. They give an adequate estimate of risks to be evaluated by investors before investing.

4) Standard Deviation (SD):

The total risk (market risk, security-specific risk and portfolio risk) of a mutual fund is measured by ‘Standard Deviation’ (SD). In mutual funds, the standard deviation tells us how much the return on a fund is deviating from the expected returns based on its historical performance. In other words, can be said it evaluates the volatility of the fund.

The standard deviation of a fund measures this risk by measuring the degree to which the fund fluctuates in relation to its average return of a fund over a period of time.

In other words, it is a measure of the consistency of a mutual fund’s returns. A higher SD number indicates that the net asset value (NAV) of the mutual fund is more volatile and, it is riskier than a fund with a lower SD.

Note: For SD to be an effective tool, investors will need to use it in comparison with peer group mutual funds. For example, a large-cap mutual fund is to be compared with a large-cap mutual fund with the same investment objective(s).

5) Sharpe Ratio:

Sharpe ratio (SR) is another important measure that evaluates the return that a fund has generated relative to the risk taken. Risk here is measured by SD. It is used for funds that have low correlation with benchmark index. This ratio helps an investor to know whether it is a safe bet to invest in this fund by taking the quantum of risk.

The higher the Sharpe ratio (SR), the better a fund’s return relative to the amount of risk taken. In other words, a mutual fund with a higher SR is better because it implies that it has generated higher returns for every unit of risk that was taken. On the contrary, a negative Sharpe ratio indicates that a risk-free asset would perform better than the fund being analyzed.

It tries to find out the excess return generated by a mutual fund over and above a risk-free rate of return such as an RBI bond or a post-office savings scheme, etc.

Let’s say the Sharpe ratio = 0.957 for a fund. As discussed above, the higher this ratio, the better a fund’s return relative to the amount of risk taken. Here, this fund could be a risky investment option for their investors since ratio is just near to 1 (approx.).

These five concepts to evaluate a mutual fund’s risk will enable an investor to take a wise decision on his mutual fund investments. An investor should not blindly invest by considering only past returns mentioned, but needs to do some research of the fund schemes and reviewing their performance at regular intervals.

However, the above measures cannot be viewed in isolation while evaluating the risks of investing in a mutual fund scheme. Other important parameters such as the corpus held, disclosure norms followed by the AMC, portfolio composition, consistency in investment objectives and strategy must also be considered.

Anoop N

Dilzer Consultants Pvt Ltd