What are Different Risk Ratios in Mutual Funds?
Last Updated : July 17, 2019, 12:37 p.m.
It’s a fact that mutual funds are subject to varied market risks. You know it, right? But are you aware of the risk ratios of a mutual fund scheme? If No, then you should be. It will give you a chance to evaluate the risk involved in the mutual fund performance. A proper evaluation can help you invest wisely in an MF scheme and achieve your objective. So, what are the different risk ratios in a mutual fund? To know the answer, you can read the post further.
Types of Mutual Fund Risk Ratios
There are basically five ratios – Alpha, Beta, R-Squared, Standard Deviation and Sharpe Ratio – in mutual funds. Let’s read these ratios one after another.
Alpha
This ratio basically determines the difference between the expected and actual returns from a mutual fund . It is computed by the following formula.
Alpha = [(Fund Return-Risk-free Return)]-(Fund’s Beta) (Benchmark Return-Risk-free Return)
A positive Alpha means the fund has surpassed its benchmark index in terms of performance. The negative Alpha, on the other hand, would mean, the fund has delivered a below par performance.
Beta
Beta measures the volatility of a particular fund compared to the market as a whole. It shows the extent to which the market factors impact the mutual fund returns. The regression analysis is used to calculate Beta. Benchmark indices such as Sensex and Nifty have a Beta of 1.0.
What Does it Mean If the Fund has Beta of 1.0 and Around?
If the fund has a beta of 1.0, it indicates the movement of NAV in the same way to that of the benchmark index. The fund will rise and fall in the same proportion to that of the benchmark index. A beta less than 1.0 would mean the fund would be less volatile compared to the benchmark index. A beta more than 1.0 indicates the fund to be extremely volatile than the index. If the rise of the fund having a beta of more than 1.0 is much more compared to its index, the fall can be even more drastic.
R-squared
This ratio measures the correlation between Beta and its benchmark index. You need to see beta from the point of R-squared to properly gauge the fund risk. R-squared values range from 0 to 1. If the beta of the fund has an R-squared value between 0.75 and 1, you can then trust the fund. In case the R-squared value is found to be less than 0.75, it means the comparison of the fund is made against an inappropriate index. The fund won’t provide similar returns to that of the index.
Standard Deviation
It measures the total risk including market risk, portfolio risk and security-specific risk of a mutual fund. It indicates the extent to which the return is deviating from the expected returns on the basis of past performance. A higher standard deviation would mean the NAV of the fund is more volatile and riskier compared to fund with a lesser deviation.
Sharpe Ratio
This ratio helps evaluate the returns generated by the fund relative to the risk taken. It’s the standard deviation that measures the risk. This is generally used for funds showing less correlation with the benchmark index. Sharpe Ratio will tell you whether you should be investing in the fund considering the risk involved in it. Greater the ratio, the higher are the returns of the fund relative to the risks and vice-versa.
Disclaimer – “Mutual fund investments are subject to market risks. Please read the scheme document carefully before investing”.