Monday, 12 September 2016

Choose Your Own Mutual Fund



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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