Understanding mutual funds is not a simple task. Especially if you are not paying attention to the performance of markets more often than you can. One significant mistake that you could make is to measure the performance of the mutual fund just on the basis of the returns it makes. As you may have heard or read "mutual funds are subject to market risks," which is exactly why you have to weigh in the risk factor every time you look at the returns made. You have to look at the risk-adjusted returns.
In simpler words, we have seen how 2017 was a good year for equity markets, with not many lows or too much volatility. As a result, the returns were higher and the assets managed by mutual funds crossed 20 trillion in August 2017.
However, in 2018, there were market corrections and high volatility, which goes to show that you cannot expect the same results looking at the historical data of a short period without understanding the risks that were involved in getting those high returns.
In 2017, 80 percent of the large-cap mutual funds were beating their respective benchmarks and by March 2018, the numbers were halved to 40 percent of the funds.
You have to make sure that the fund you have selected is in the 40 percent. For that, you will have to make a decision based on the past performance of the funds. For example, in 2017 if two funds gave the same returns of 10 percent, look at how much risk was involved in getting that gains for both the funds. Can the fund you choose beat volatility to give the same results?
To differentiate between risk-adjusted returns and overall returns, look at the risk-adjusted ratio when you pick the fund. If the ratio is higher, it is better. To simplify it, the past performance ratios can be taken into consideration for your selection.
How to look at risk ratios?
The selection of the funds is again based on your needs. How much returns do you expect? How much risk are you willing to take? What is the level of risk that you are willing to take? And so on.
Now coming to reading the risk ratio. When you look at a typical ratio it will be in the formula of return/risk. Which means that the numerator will be a measure of your return while the denominator will show you risk. The six ratios basically used to measure performance are:
- Sharpe Ratio
- Treynor Ratio
- Upside Capture Ratio
- Downside Capture Ratio
- Information Ratio
- Sortino Ratio
Each ratio serves a different purpose and is used based on the investor needs. You may look for consistent returns, short-term high returns, etc. The ratios will look at particular situations only. For example, the Sortino ratio measures risk only on the downside, ie. volatility is only a concern when returns are low. Sharpe ratio, on the other hand, gives you a measure of the excess return that you can make over and above the risk-free rate (government bond yields for example given risk-free returns).
Once you are decided on your investment goal, you can go help and analysis historic data on mutual funds using ratios to look at the risk-adjusted ratio.