Mutual Fund Performance Measures - How to measure Mutual Fund risk
Often investors tend to look at investments only for producing maximum returns for the cash they invest. Often, with this point of view, before making a choice, they hardly look at their risk profile and the investment risk. Nearly all investments come with a certain degree of risk. If your return on these investments is not commensurate with the risk associated with it, then making these investments may not be fruitful.
A successful mutual fund is the one which, given the same risk, provides better yields in its category.
While returns can be readily tracked, how can the risks connected with mutual funds be determined or measured?
There are four main investment risk indicators for analyzing portfolios of mutual funds. These are alpha, beta, standard deviation, and the ratio of Sharpe. These statistical measurements are historical predictors of risk/volatility for investment. All of these risk measurements are designed to help investors determine their investment's risk-reward parameters. Here is a short description of each of these common indicators.
Alpha is a risk-adjusted measure of the performance of an investment. It takes a security or fund portfolio's volatility (price risk) and compares its risk-adjusted performance to a benchmark index. The investment's excess return relative to the benchmark index return is its alpha. Simply stated, alpha is often regarded as representing the value-added or subtracted from the return of a fund portfolio by a portfolio manager. A 1.0 alpha means that the fund has exceeded its benchmark index by 1%. A -1.0 alpha would correspond to the underperformance of 1%. The higher the alpha, the better for investors. Let's say you're investing in an XYZ mutual fund with BSE Sensex as the benchmark. Let's also assume that in a specific year BSE Sensex has yielded a return of 12 percent. If the alpha value is positive 3.0, then XYZ has outperformed its benchmark index by 3 percent and given 15 percent as returns for that particular year. Similarly, a negative 3.0 alpha may mean that XYZ has been underperforming in comparison with BSE Sensex and given 9 percent as returns for the particular year.
Beta, also known as the beta coefficient, is a measure of a security or portfolio's volatility, or systematic risk, compared to the entire market. Beta is calculated using regression analysis and represents the return tendency of an investment to respond to market movements. The market has a beta of 1.0 by definition. Individual values of security and portfolio are measured by how they deviate from the market.
A beta of 1.0 shows that the price of the investment will move with the market in a lock-step. A beta of less than 1.0 shows the investment is going to be less volatile than the market. A beta of more than 1.0 indicates, therefore, that the price of the investment will be more volatile than the market. For instance, if the beta of a fund portfolio is 1.2, it is 20 percent more volatile than the market theoretically.
Conservative investors who want to maintain capital should focus on low beta securities and fund portfolios while investors who are willing to take on more risk in search of higher returns should look for high beta investments.
Furthermore, when looking at beta, it is always preferable to also verify how carefully your portfolio of mutual funds mirrors the benchmark. R2 or R-Squared is a statistical measure explaining the extent to which the portfolio motion reflects the benchmark index motion. R-Squared values range from 0-100. R-Squared's value must be greater than 80 to show a strong benchmark correlation with the portfolio of the mutual fund. Beta may not be as efficient if the benchmark is not tightly followed by your portfolio.
Standard deviation measures data dispersion from its average. In essence, the more data is distributed, the higher the difference from the norm. Standard deviation in finance is applied to an investment's annual return rate to assess its volatility (risk). There would be a high standard deviation in a volatile stock. The standard deviation with mutual funds informs us how much a fund's return deviates from the anticipated yields based on its historical performance.
For instance, if the XYZ portfolio has a normal deviation of 7% and an average return of 15%, it implies that it tends to deviate by 7% from its anticipated average return and can produce returns from 8% to 22%. Standard deviation is immediately commensurate with portfolio volatility. It is also used to calculate the ratio of Sharpe.
The Sharpe ratio measures performance that is risk-adjusted. It is calculated by subtracting the risk-free rate of return for an investment from the rate of return and dividing the outcome by the standard deviation of the return of the investment. The Sharpe ratio informs investors whether the returns of an investment are due to wise investment choices or an excess risk outcome. This measurement is helpful because while a portfolio is capable of generating greater yields than its peer, it is only a good investment if those greater yields do not come with too much extra risk. The higher the Sharpe ratio of an investment, the better its risk-adjusted-performance.
Many investors tend to concentrate solely on returns on investment with little investment risk concern. The four risk measures we talked about can provide some equilibrium to the equation of risk-return. As helpful as these measurements are, volatility risk is just one of the variables that you should consider that can influence the quality of a mutual fund investment.