Mutual funds invest in avenues based on their mandate, they generally have a risk profile. Anyone who intends to invest in mutual funds should consider the risk profile and invest accordingly. Some funds carry a lower risk as compared to others, within the category, there may be funds that are of relatively higher / lower risk. To assess the risk one should consider certain risk ratios which will help ascertain if the fund is suitable to your risk appetite. Mutual funds offer unprecedented diversification and help optimise returns by mitigating risk efficiently.
What are risk ratios?
Financial risk in mutual funds assesses the risk of downside in mutual funds. A mutual fund is a pool of money that is invested in multiple securities based on the mandate. The risk of this is assessed based on a few fundamental factors associated with the underlying assets.
Types of risks
There are two types of risks associated with markets:
Systematic risk
This risk is inherent to the entire market and is un-diversifiable. One cannot reduce the risk by any means.
Idiosyncratic risk also called unsystematic risk –
This risk is an inherent factor that could potentially impact specific stocks. This risk can be eliminated by means of diversification.
While one can evaluate both risks, it is quite apparent that one can reduce only idiosyncratic risk by adding assets that are negatively correlated with each other.
Some of the key ratios considered for assessing mutual fund risk are:
1. Variance
2. Beta
3. Sharpe Ratio
4. Alpha
5. R-squared
6. Standard Deviation
Variance:
Variance is a measure that evaluates the dispersion of returns from the mean returns of the asset. This measure is called volatility of the stock, if the returns of the stock fall farther away from the mean returns during the period considered.
For mutual funds, the variance is applied to the annual mean returns which depict the volatility of the mutual fund. The standard deviation, which is the square root of the variance of the mutual fund is compared to that of the other funds within the category.
Tip: The one with the lowest standard deviation indicates a fund with relatively lower risk in the category.
Beta:
The beta coefficient is a measure of systematic risk, it measures the relative risk of the mutual fund vis-à-vis that of the market. It is a relative measure, ideally, the comparison of the Beta of a particular mutual fund should be made with the variance of the respective benchmark indices.
The benchmark of the mutual fund will be pre-determined based on the fund objective and mandate.
a. A beta of 1.0 is indicative of the mutual fund has a similar movement pattern to that of the market.
b. A beta of lower than 1.0 indicates that the mutual fund has lower volatility than that of the market.
c. A beta of higher than 1.0 indicates that the mutual fund carries higher volatility than that of the market.
Tip: In relation to this, it can be understood that the market beta is equal to 1.0. Investors with a conservative demeanour should opt for mutual funds with a lower beta.
Sharpe Ratio:
This ratio is a measure of returns per unit of risk assumed. It is measured as the excess returns of the mutual fund over the risk-free rate of return which is then divided by the square root of variance or standard deviation for the given period.
The higher the Sharpe ratio, the better the risk-adjusted performance. A ratio of 1 or above is considered good, 2 or greater is considered very good, and 3 and above is considered excellent.
Tip: It is best to look at how the Sharpe ratio has moved over a longer timeframe to ascertain how it has fared over different market cycles.
Alpha ratio:
This ratio provides information on the mutual fund performance in comparison to the benchmark index. A higher Alpha means higher relative performance as compared to that of the benchmark. The excess returns of the investments relative to the returns of the benchmark are termed alpha.
Tip: The alpha is considered the expertise that the fund manager brings to the mutual fund. If it is positive then it means that the fund manager has managed to outperform the benchmark; if the alpha is negative, then there is underperformance.
R-squared:
R-squared is another mutual fund risk ratio that evaluates the fund's performance. It measures the percentage of variation in a fund that is explained by a benchmark index's performance. Investors use this ratio to determine if a fund is managed actively or passively.
An actively managed fund outperforms its benchmark index. As a result, it has a lower r-squared value. On the contrary, a passively managed fund replicates the benchmark performance. Therefore, it typically has a higher r-squared value. This ratio helps investors distinguish low-risk mutual funds from high-risk mutual funds, evaluate their performance, and determine if the fund manager is actively making decisions or simply tracking the benchmark.
Tip: The r-squared value ranges from 0-1. If you want to check your mutual fund performance, then you must look out for this ratio. If the value is 1, it means your fund's returns match the benchmark returns. But if the value is 0, it indicates that there is no relationship between the fund and benchmark returns.
Standard deviation:
Standard deviation measures the overall mutual fund risk. This includes market risk, security-specific risk, and portfolio risk. It indicates the fluctuations in your mutual fund's returns over a specific period. In simple words, standard deviation indicates how much your actual returns are deviating from the expected returns based on the fund's historical performance.
Investors use this ratio to evaluate the risk profile of a mutual fund and compare it with other funds. The ratio is directly proportional to the portfolio volatility and is also used to calculate the Sharpe ratio in mutual funds.
Tip: A higher standard deviation indicates high-risk mutual funds, whereas a lower standard deviation indicates low-risk mutual funds.
It is very important to know all the risks associated with a portfolio to be able to take an accurate investment decision. The expert team at Tata Capital Wealth helps you decide on the right funds, if the risk measures seem too complicated, then reach out to a professional who can guide you appropriately.
30 March 2022
6 mins read
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