Most of the times investors get excited to see the high returns and forget to calculate the risk involved. SEBI or Securities and Exchange Board of India have introduced a system to safeguard the interest of the investors with regards to mutual funds in India. So now it is mandatory for companies to share their payouts as applicable in India. But to be on the safer side, the investors should do their own risk evaluation.
There are 5 ways to measure mutual fund risk.
- Alpha – This measure gives the risk-adjusted indication calculated against a benchmark.
Alpha = The actual rate of return of portfolio — expected rate of return of a portfolio
Say the expected returns were 20%. Then, a positive alpha of 2.0 is equivalent to the fund over-performing by 2% and resulting in a 22% return in a specific given year. Similarly a negative alpha of 2.0 means underperforming by 2% and only giving 18% of returns.
- R-squared – It simply measures the relationship between a benchmark and a portfolio. R-squared is not indicative of how a portfolio is performing but it is indicative of how the portfolio is meeting the benchmarks. Often high r-squared ratio is a pointer to a closet index fund as it shows the benchmark or coefficient is not properly set. Such funds should be avoided by investors. R-squared ranges from 0 to 1. An R-squared value of 0.75 to 1 can be trusted.
R-squared = Square of Correlation
(Correlation can be found out by dividing Covariance between index and portfolio by Standard deviation of portfolio multiplied by the standard deviation of the index)
- Beta – This is a significant measure as it denotes how well the particular funds perform given the volatility of the market in a given year.
Beta = Standard Deviation of Fund / Standard Deviation of Benchmark x R-Square.
So beta = 1 means no movement in the market. Beta > 1 means the funds have outperformed market expectations. Beta < 1 indicates the fund in question is not meeting market expectations.
- Standard deviation – A fund with a high standard deviation indicates that the prices are volatile. It is a good indication of how consistent the performance of the fund has been. It mainly evaluates portfolio risk, the specific risk involved with securities and of course market risk.
Standard deviation = Square root of the variance
The variance here means the total sum of the squared difference between each monthly return and its mean divided by a number of monthly return data.
- Sharpe’s ratio – Sharpe’s ratio helps understand how much return a fund has given in proportion to the risk taken. As it is a risk-adjusted method of calculation, it is compared among its peers in the market. A fund with a high Sharpe’s ratio has definitely done better than what was expected.
Sharpe Ratio = (Expected portfolio return – Risk free rate of return) / Standard deviation of portfolio return / volatility.
The risk involved in mutual funds cannot be calculated on the basis of these calculations alone. Other factors that influence mutual fund investment are total investment, volatility risk and investment distribution.
Fortunately, for investors who want to avoid such calculations, the risk measure information is available online from reliable sources like Kotak Securities.