How to Manage Risk of Mutual fund? Alpha, Beta, Standard Deviation, Sharp Ratio, Sortino Ratio.

How to Manage Risk of Mutual fund? Alpha, Beta, Standard Deviation, Sharp Ratio, Sortino Ratio.

 

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How To Manage Risk in Mutual Fund

5 Ways to Measure Mutual Fund Risk

Standard Deviation

It Predicts the amount by which the return may go up and down in correlation with average return or its means.

Standard deviation measures the dispersion of data from its mean. Basically, the more spread out the data, the greater the difference is from the norm. In finance, standard deviation is applied to the annual rate of return of an investment to measure its volatility (risk). A volatile stock would have a high standard deviation. With mutual funds, the standard deviation tells us how much the return on a fund is deviating from the expected returns based on its historical performance.

R-squared

It shows the reliability of Beta.

R-squared values range from 0 to 100. According to Morningstar, a mutual fund with an R-squared value between 85 and 100 has a performance record that is closely correlated to the index.

Beta

It Predicts performance of fund in correlation with index.

Beta, also known as the beta coefficient, is a measure of the volatility, or systematic risk, of a security or a portfolio compared to the market as a whole. A beta of 1.0 indicates that the investment's price will move in lock-step with the market. A beta of less than 1.0 indicates that the investment will be less volatile than the market. Correspondingly, a beta of more than 1.0 indicates that the investment's price will be more volatile than the market. For example, if a fund portfolio's beta is 1.2, it is theoretically 20% more volatile than the market.

Conservative investors who wish to preserve capital should focus on securities and fund portfolios with low betas while investors willing to take on more risk in search of higher returns should look for high beta investments.

Alpha

It shows the return over the predicted return by Beta.

Alpha is a measure of an investment's performance on a risk-adjusted basis. It takes the volatility (price risk) of a security or fund portfolio and compares its risk-adjusted performance to a benchmark index. The excess return of the investment relative to the return of the benchmark index is its alpha. Simply stated, alpha is often considered to represent the value that a portfolio manager adds or subtracts from a fund portfolio's return. An alpha of 1.0 means the fund has outperformed its benchmark index by 1%. Correspondingly, an alpha of -1.0 would indicate an under-performance of 1%. For investors, the higher the alpha the better.

Sharpe Ratio

Return generated per unit of Risk taken.

It is calculated 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 tells investors whether an investment's returns are due to wise investment decisions or the result of excess risk. This measurement is useful because while one portfolio or security may generate 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 an investment's Sharpe ratio, the better its risk-adjusted performance.

Sortino Ratio

Similar to Sharp ratio.

Return generated per unit of Bad Risk taken.

Higher Sortino Ratio means fund is taking lower down risk

CONCLUSION

Investments and risks will always go hand in hand, but if you can use mutual funds well as an investment route, you can protect yourself adequately from the many market risks.

Compare these ratios with same category of fund.

Don't select any fund by considering any ratio in isolations.

‘There is no scientific way to choose tomorrow’s best funds today’, so one should review the current selection every quarter or half yearly.