5 Ratios Used to Calculate Mutual Fund Risk Explained

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    There are some statistical measures that one can use to analyze the risk of investments in mutual funds or stocks. Any investor looking to make investments would want to make a calculated decision to understand which investment would yield better with minimal risk.

    These ratios help predict risk and volatility of the mutual fund based on historical data. They are often used to assess the performance of a company's equity or fixed income or mutual fund against a benchmark.

    If you are not aware, a benchmark is a standard against which you can compare the performance of a mutual fund/share to access its performance. For example, if you want to analyze the performance of the share price of a large-cap bank in India, you can compare it with Bank Nifty, and check if it outperformed or underperformed in comparison with the average of the other bank stocks.

    Standard Deviation
     

    Standard Deviation

    The standard deviation as the name suggests, shows you how much the results (returns from a fund) have deviated from the mean. Mean is the average returns and standard deviation will show you whether the returns were positive or negative when compared to the mean.

    When it is being calculated, if the historic data is too scattered from the mean, the standard deviation will be higher. The higher the number, the higher the volatility (risk) of the mutual fund. It tells you how much your returns can deviate from the expected average returns based on the historic data.

     

    Sharpe Ratio

    Sharpe Ratio

    Sharpe ratio was named after Nobel laureate economist William Sharpe who developed it. The ratio measures the excess returns that a fund can make over and above the risk-free rate. For the risk-free measures, government bond yields are usually taken as the base, because unless government falls, the returns are guaranteed. So, if you want to calculate the returns of a three-year fund, it will be compared with the yield of the government bond.

    In its formula, (return rate of the fund-risk free rate)/standard deviation of the fund, the numerator will tell you how much the fund will give over and above the risk-free rate, while denominator will show you its volatility.

    This way, not only will you get a measure of the average returns but the consistency of the fund in delivering them because the average could be higher due to one good year of performance.

    Beta
     

    Beta

    Beta (beta coefficient) is a measure of volatility (risk) of the mutual fund against that of the market as a whole. Your investment can be affected by a factor that affects the market as a whole (like political tensions) or specific to the industry or company you have invested it (new regulations or deal made). If you are a diversified investor, you will not be too concerned about company-specific investments but rather the tendency of change in behaviour of your portfolio to the changes in the market.

    Typically, 1.0 indicates that the investment will move with the market. If the investment has a 1.2 result, for instance, it means that the investment is 20 percent more volatile than the market. If you are a conservative investor, look at low betas and vice-versa.

    Treynor Ratio

    Treynor Ratio

    Treynor ratio differs from Sharpe only in the denominator, which means its measurement of risk is the only thing that varies.

    The formula is (return rate of the fund-risk free rate)/beta of the fund. Again, this is beneficial to those investing in diverse funds. If you are investing in only two or three, you can look at Sharpe to understand the nature of that particular fund.

    Sortino Ratio

    Sortino Ratio

    Not everyone is concerned with inconsistency in the fund's returns. Some wish to know how many times that returns have over-performed. The focus is on returns only and the possibility of their fund will bring them losses.

    The formula for Sortino ratio is (return rate of the fund-risk free rate)/downside deviation of the fund. While Sharpe shows the volatility of the fund whether it gives high returns or low returns, the Sortino only focuses on low returns. Therefore, if as an investor you do not care about the high return risk but only want to know the risks of your returns going down, Sortino is your analysis ratio. Good fund managers typically have a higher Sortino ratio as they are able to manage the fund's downside risks well, irrespective of market performance.

    Read more about: mutual funds
    Story first published: Friday, July 20, 2018, 17:56 [IST]
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