Explainer: Which ratio to look at while buying a mutual fund?

Mutual fund investors only look at the past performance while choosing any equity scheme. There are other parameters that one should look at while choosing the correct scheme. An investor should remember to consider risk ratios also while checking the returns of schemes.

What are the risk ratios? What is risk analysis? Investment through mutual funds limits both unsystematic as well as systematic risks. Unsystematic risk is eliminated by selecting companies with sound fundamentals while systematic risk is restricted to an extent by creating a low beta portfolio.

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The thing we have to do is to understand how to use these risk measures to choose the best mutual funds. Now, let us look at some of the statistical ratios to assess the risk profile of the funds.

Alpha: Alpha is also known as Jenson. Jenson is basically the difference between the mutual fund’s actual return and its expected performance given its level of risk as measured by beta. This ratio is used to analyse the performance of an investment manager. A positive alpha indicates that the fund has managed to perform better than its benchmark. A positive alpha of 1.0 means the fund has outperformed its benchmark index by 1%. On the other hand, a negative alpha of 1.0 indicates the underperformance of 1% by the fund vis-à-vis its benchmark. This ratio is also interpreted as the value that a portfolio manager or the fund manager adds, above and beyond its benchmark index.

Alpha = RP – [ RF + βP (RM – RF)]

Where: RP = Expected total portfolio return, RF = Risk free return, ΒP = Beta of the portfolio, RM = Expected market return

Jensen’s alpha can be classified into two types — return due to net selectivity and return due to improper diversification. Return due to net selectivity indicates that the stock selection made by the fund manager while return due to improper diversification indicates excess returns which are generated on account of concentrated bets on stocks and sectors. In simple words, returns that are generated due to improper diversification of the portfolio.Beta: Beta is a tool that is used to measure volatility or systematic risk of a mutual fund. Beta is the correlation of the fund with the market. Ideally the beta of the market is 1.00. Beta of less than 1 indicates that the fund is less volatile than the market. Similarly, beta greater than 1 means the fund is more volatile than the market or benchmark.

R-square: The coefficient of determination also called R2 is used to ascertain the significance of a particular beta. Higher R2 indicates a more reliable beta. If the R-squared is lower, then the beta is less relevant to the fund’s performance.

Sharpe: The sharpe ratio tells an investor whether a portfolio’s returns are due to smart investment decisions or a result of excess risk. Although one portfolio or fund can reap higher returns than its peers, it is only a good investment if those higher returns do not come with too much additional risk. The greater a portfolio’s Sharpe ratio, the better its risk-adjusted performance has been. A negative Sharpe ratio indicates that a risk-less asset would perform better than the security being analysed. So higher the sharpe ratio the better is the fund.

Sharpe Ratio = (RP – RF) / σP

Where: RP = Expected Portfolio Return, RF = Risk Free Rate, σP = Portfolio Standard deviation,

A variation of the Sharpe ratio is the Sortino ratio, which removes the effects of upward price movements on standard deviation to measure only return against downward price volatility.

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Treynor: It is a risk-adjusted measure of return based on the systematic risk. It is considered similar to the Sharpe ratio, with the difference being that the Treynor ratio uses beta as the measurement of volatility.

(Average Return of the Portfolio = Average Return of the Risk-Free Rate) / Beta of the Portfolio.

Information Ratio: The information ratio measures a portfolio manager’s ability to generate excess returns relative to a benchmark, but also attempts to identify the consistency of the manager. This ratio will identify if a manager has beaten the benchmark. The higher the ratio the more consistent a manager is and consistency is an ideal trait.

Information Ratio = (RP – RF) / SP-I

Where: RP = Return of the Portfolio, RF = Return of the Index, SP-I = Tracking Error

Sortino Ratio: This ratio measures the risk-adjusted return of an investment or portfolio. It is a modification of sharpe ratio that takes into account the standard deviation of negative asset returns called downside deviations. Higher the Sortino ratio higher is the return per unit of risk taken by the fund manager.

Sortino Ratio = (RP – RF) / σD

Where: RP = Return of the Portfolio, RF = Risk Free return, σD= Std dev of –ve returns

Semi – Std Deviation: Unlike Standard deviation, which measures overall volatility in NAV, this ratio measures only downside volatility. Thus, it ignores the upside volatility which is ideal and desirable in any portfolio. The lower the value of semi std deviation, the lower is the downside potential of a fund.