With increasing demand of Mutual Funds, people are always looking for Best Mutual Fund Investment Options. But how do you access if the Mutual Fund is good for your or not? In the financial market, there are a few instruments that quantify the performance, response and interaction of a mutual fund.
The five main risk indicators that apply to the analysis of bonds, stocks, and mutual fund are;
Alpha
Beta
R-Squared
Standard deviation
Sharpe ratio
These statistical measures are major components of modern portfolio theory (MPT) and are historical predictors of the risk or volatility of the investment. Modern Portfolio Theory is a standard methodology that is used to assess the performance of the mutual fund, fixed income, and equity by comparing them to the market benchmarks.
The risk indicators are primarily used to help investors understand the risk/reward parameters of their investments.
1. Alpha:
This measures the performance of the investment on a risk-adjusted basis. Alpha uses the volatility of a fund portfolio or securities and compares it with risk-adjusted performance to a benchmark index. In simple terms, alpha represents a value that a portfolio manager adds or subtracts from a fund portfolio’s return.
An alpha of 1.0 indicates that the fund has outperformed the benchmark index by 1% while a -1.0 indicates an underperformance of 1%.
Higher the alpha, better it is for the investors.
2. Beta
This is also known as the beta coefficient and helps measure the volatility or systematic risk of a portfolio or a security that is compared to the market as a whole. Beta represents the ability of an investment’s return to respond to movements and is calculated using regression analysis.
There are three ways of interpreting beta numbers:
A beta of 1.0 indicates that the fund NAV will move in tandem with the benchmark index.
A beta of less than 1.0 signifies that the fund NAV is less volatile than the benchmark index.
A beta of more than 1.0 indicates that the NAV will be more volatile than the benchmark index. It means that it is an aggressive fund that will move higher than the benchmark but will also fall steeply.
As a rule of thumb, investors looking to preserve the capital should focus on fund portfolios and securities with lower betas. On the other hand, investors who are willing to take on more risk can consider investments with high beta.
Note: The best time to analyze the alpha and beta value is one year returns from their funds.
R-Squared:
R-squared represents the percentage of fund portfolio or a security’s movements that can be explained by movements in a benchmark index. Simply put, R-squared measures the correlation between beta and its benchmark index. For better understanding, the risk of the fund, the beta of a fund has to be seen in conjunction with the R-squared.
This statistical measure ranges between 0 and 100 and mutual funds with R-square value between 85 and 100 have a performance record closely correlated to the index. A fund rated 70 or less does not perform like the index.
It is recommended that investors stay away from actively managed funds having high R-squared ratios. These funds are criticized by analysts and are often known as closet index funds.
Standard deviation
This measures how far the data is from its mean. It implies that the more spread out the data is, the greater is the difference from the norm. The standard deviation is used to measure the volatility of the annual rate of return of an investment.
A high standard deviation signifies a volatile stock. In mutual funds, the standard deviation helps us understand how much the return on a fund is deviating from the expected returns based on its previous performance.
Sharpe Ratio
Sharpe ratio measures the risk-adjusted performance and was developed by economist William Sharpe (Nobel laureate).
The value is obtained by subtracting the risk-free rate of return from the rate of return for an investment and dividing the result by the investment’s standard deviation of its return.
The Sharpe ratio enables an investor to understand if an investment’s returns are a result of good investment decisions or due to excess risk.
Sharpe ratio is vital as one portfolio or security may offer higher returns than others and it is good to understand that those returns do not come with additional risks. The higher the Sharpe ratio, the better is its risk-adjusted-performance.
Conclusion
The above-mentioned indicators will enable investors to evaluate a mutual fund’s risk and take a wise decision on his mutual fund investments. It is recommended that you do some research on the fund schemes and not blindly invest by considering only the past returns.
Additionally, you must consider other important parameters such as disclosure norms followed by the AMC, corpus held, portfolio composition and consistency in investment objectives.