All mutual fund investments are
subject to market and performance risk. Hence, while we choose any particular
fund to fulfill our goal, we need to study its past performance and analyze its
probable performance. Every mutual fund can be commonly
judged on the following ratios to grade it quantitatively. These ratios are
basically the risk measures of every fund stating the risk reward balance.
a) Standard
deviation (SD) – As
the name suggests, this particular measure is used to calculate the deviancy of
any particular fund over a specific period of period based on its historical
performance. Let us understand with an example:
Fund name
|
Kamaal
|
Double Kamaal
|
Past 1 year return (%)
|
15%
|
15%
|
Standard deviation (%)
|
12%
|
14%
|
Although
both the funds above have same return in past 1 year, the fund with higher SD
is considered to be move risky than the other.
b) Sharpe
ratio – this ratio
is used to calculate risk adjusted return of a portfolio over and above the
average risk free return of portfolio. It is useful to understand what the
actual return is earned by a portfolio over the zero risk investment. Higher the Sharpe ratio better is the investment. Let
us understand it with an example:
Fund name
|
Kamaal
|
Double Kamaal
|
Past 1 year return (%)
|
15%
|
15%
|
Risk free return (%)
|
5%
|
5%
|
Standard deviation (%)
|
12%
|
14%
|
Sharpe ratio
|
0.83
|
0.71
|
Fund
with higher Sharpe ratio indicates that the fund is more likely to give profit
even with higher risk taken. Negative Sharpe ratio
means is not good enough for sustainable long term investment.
c) Beta – Beta measures the change in fund
return to change in benchmark index performance. It is always closer to 1.
Lower than 1 indicates lower beta and higher than 1 means higher beta. Thus, if market goes up, fund with lower beta will go down
and if the market goes down, fund will come up. Hence, higher the
correlation of mutual funds with the underlined fund, better the reading of the
Beta of fund.
d) Alpha –It is a comparative ratio. It is used to compare the fund performance against
the benchmark Index. It helps to understand if the stock has outperformed or
underperformed against the Index. Further it can be used to see the best
performing fund in the index. It is calculated as follows:
Past 1 year
return (%) – [Risk free return + (average market return - risk free rate)*
beta]
So suppose – fund
performance – 15%, risk free return – 5%, beta – 0.71, average market return
18%, then alpha is around 1%. This means the fund has outperformed the expected
market return by 1%.
e) R-Squared – it is studies the relation
between Beta of fund and benchmark index.
Summarizing,
Standard
Deviation
|
Lower
the SD, better the mutual fund.
|
Sharpe
Ratio
|
Good
fund -> Low SD & Higher Sharpe
ratio
Volatile
fund -> High SD & Lower Sharpe ratio
|
Beta
|
Higher beta funds expected to give you
profit in Bullish markets and low beta fund is preferred in a bearish market
expectation.
|
Alpha
|
Higher
the Alpha, better the mutual fund performance is.
|
Regards,
Saarthi Financial Planners
www.saarthifp.blogspot.in
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