The Art Of Risk Calculation In Mutual Funds

 People often associate risk with luck, and while that may be true to an extent, the major difference is that unlike luck, risk can be measured. Now before we get into the ratios that help us measure how much risk is attached to a particular mutual fund, an important concept to understand is volatility. Volatility is basically the measurement of how erratic a particular fund is, so if a particular fund is highly volatile, what this means is it has a tendency to either rise or fall sharply in a relatively short period of time. This is why volatile funds are generally considered high risk.

Alpha

With an Alpha ratio, instead of comparing a fund's performance to its own average like some other ratios, we’re comparing its risk-adjusted return with a benchmark (example Sensex, Nifty). This is why an alpha ratio can be either negative or positive, with a negative ratio indicating a fund that is underperforming in comparison with its benchmark. For example, an alpha ratio of +3 indicates a fund that outperformed its benchmark by 3%, while -3 would indicate a shortfall of 3%.

Beta

Also called the beta coefficient, this one is a little different than the others since the value is going to be a fraction above 1 or a fraction below 1. What it is, is a measurement of the fund’s tendency to shadow the market as a whole, or to shadow a particular benchmark or index. So a value below one, like 0.7 for example, would indicate a fund that shadows the market up to 70%, so for every 1% change in the market, up or down, you can expect a 0.7% change in the fund. Similarly, a value above one, like 1.3, would indicate a fund that’s 30% more volatile.

Standard Deviation

This one is quite simply what we just explained with the definition of volatility, and is the measurement of how volatile a particular fund is, in relation to its own average. To elaborate, if a particular fund has an average return of 20% but also has a standard deviation of 10%, this means it could go 10% to 30%, or down 10%.

R-Squared

Since the Beta can be calculated against the market as a whole or any other benchmark, this can be misleading if the benchmark in question isn’t appropriate. This is why we have the R-Squared ratio which indicates the “relationship-level” between the fund and the index that’s being used to measure the Beta. R-Squared ratios go from 0-100, and while a 70 - 100 indicates an appropriate benchmark is being used and the Beta ratio can be trusted, anything below implies the Beta ratio is not a useful indicator.

Sharpe’s Ratio

Last, but definitely not least on our list, is the ratio developed by renowned economist and Nobel laureate William Sharpe, and is probably the most interesting of them all. Suppose a particular fund is performing really well and you are feeling really good about increasing your investment. What Sharpe’s ratio will tell you is whether the previous returns were due to smart choices by the fund manager or just higher risks being taken. This is why going by just one ratio can often be misleading as there are always a number of factors that need to be taken into consideration.

In conclusion, while everyone always talks about mutual funds being subject to market risk, no one tells you that market risk is tangible, can be measured, analyzed, balanced, and most importantly, accounted for.


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