7 Important Ratios to consider while selecting a right Mutual Fund
Investing in Mutual Fund is inevitable. We have talked a lot about selecting right category of Mutual funds according to your financial goals, time horizon and risk appetite in our earlier blogs.
However, after selecting right category of Mutual Funds, how to select the right Mutual Fund scheme? How to compare two funds within the same category?
In this blog, we are elaborating few ratios for you. The information on these ratios will help you find better scheme for you.
1. Alpha & Beta
First of the ratios, Alpha is a measure of how much returns the Mutual Fund scheme has delivered over the market. It measures a fund’s performance to its benchmark. In simple terms, Alpha is the excess returns generated by the fund compared to benchmark.
Alpha = Actual Rate of Return – Risk-Free Rate – Beta * Market Risk Premium
Where: (Market Risk Premium = Market Return – Risk-Free Rate)
Example: Let us take the example of a Portfolio with a Beta of 1.5 that generated an Actual Return of 10% during last year. If the current Market Return is 6% and the Risk-Free Rate is 4%, then calculate the Alpha of the Portfolio.
Alpha = 10% – 4% – 1.5 * 2%
Alpha = 3%
The higher a fund’s alpha, the better it is. Alpha of 3% is indicates that it is a very good fund and has delivered much better returns than its benchmark.
Beta is a volatility parameter relative to its benchmark. A beta above 1 indicates that the fund can perform better on uptrends and fall more in market corrections. In short, a fund probably will gain more and fall more than the average. A beta below 1 indicates the reverse. High-beta funds that don’t perform well during rising market indicate that there’s something inappropriate in the fund’s strategy. High-beta funds are suitable for risk-taking investors.
The formula for beta is little complicated.
However, you do not need to remember any of the formula mentioned in this blog. All the important formulas are mentioned on the research websites. You just need to interpret those formulas and make a wise decision with the help of these ratios.
2. Sharpe Ratio
Sharpe Ratio measures the risk-adjusted returns of two or more funds within a same category. This ratio shows how much return an investor is earning in connection to the level of underlying risk. Sharpe Ratio is calculated by taking the difference between the returns of the investment (Mutual Fund) and the risk-free return, divided by the standard deviation of the asset.
Sharpe Ratio = (Fund Return – Risk-free Return)/Standard Deviation of the Fund
Investors will get an idea regarding the degree of risk that a fund took to generate extra returns over risk-free instruments, such as 10-year G-Sec bonds.
The higher the Sharpe Ratio, the better is the fund’s ability to reward investors with higher risk-adjusted returns.
Example: Let’s compare two Mutual Fund Schemes as under.
‘A’ Fund | ‘B’ Fund | ‘C’ Fund | ‘D’ Fund | |
Returns | 10% | 12% | 12% | 14% |
Risk Free Rate | 6% | 6% | 6% | 5% |
Standard Deviation | 12% | 12% | 13% | 8% |
Sharpe Ratio | 0.33 | 0.50 | 0.46 | 1.13 |
As you can see, Sharpe Ratio increases with the returns.
In short, you can interpret Sharpe Ratio as,
- Less than 1: Bad
- 1 – 1.99: Adequate/good
- 2 – 2.99: Very good
- Greater than 3: Excellent
3. Standard Deviation:
Standard deviation is a arithmetic tool that measures the deviation or dispersion of the data (here returns) from the mean or average. When it comes to Mutual Funds, it states that how much returns from your mutual fund portfolio is drifting from the expected return, based on the fund’s historical performance.
For example, if the portfolio A has a standard deviation of 6% and average return of 14%, it means that it has a tendency of deviating by 8% from its expected average return and may give returns between 7% to 22%.
Standard deviation is directly proportional to the volatility of the portfolio.
4. Sortino Ratio
Alpha, Sharpe Ratios are measures of excess Returns. However, Sortino Ratio is the one that captures downside risk of the fund. It measures a fund’s ability to cover the downside risk, especially during adverse market conditions.
It calculates the risk instead of the total volatility of the portfolio. Here, he downside risk signifies returns that fall below a minimum expected rate such as risk-free returns and/or negative returns.
For instance, a fund has generated returns of 10%, 15%, 20%, 2%, -5%, -3%, and 4% respectively, in the last seven years.
Assuming that the risk-free rate is 6%, the returns below this limit will be included. In this case 2%, -5%, -3%, and 4% returns will be considered as downside deviation because they are below risk free rate of 6%.
Sortino Ratio = (Fund Return – Risk-free Return)/Downside Deviation
All mutual funds have a possible downside risk as the returns are market linked. However, some schemes have a better ability to manage it. Thus, the Sortino Ratio is an important ratio to measure risk-adjusted returns.
‘A’ Fund | ‘B’ Fund | ‘C’ Fund | ‘D’ Fund | |
Returns | 15% | 12% | 14% | 12% |
Risk Free Rate | 6% | 6% | 6% | 6% |
Downside Deviation | 12% | 7% | 9% | 5% |
Sortino Ratio | 0.75 | 0.86 | 0.89 | 1.20 |
Lower the downside deviation, higher the Sortino Ratio.
It is similar to Sharpe Ratio. However, Sharpe ratio accounts for risk-adjustments in investments with both positive and negative returns. On the contrary, the Sortino ratio examines risk-adjusted returns, but it only considers the downside risks.
The higher the Sortino Ratio, the better is the fund’s ability of earning higher returns by not taking unjustified risk.
5. Treynor Ratio
By the definition, the Treynor Ratio is used for determining the excess returns earned per unit for a given level of systemic risk.
Treynor Ratio = (Fund Return – Risk-free Return)/Beta of the Fund
While the Sharpe Ratio considers standard deviation for calculating risk-adjusted returns, the Treynor Ratio considers the ‘Beta’ of the Mutual fund (a measure of systemic risk).
Investors invests in Mutual Funds is to reduce risk by diversification. However, systemic risk (market risk) cannot be mitigated by diversification. Hence, mutual funds should compensate investors by efficiently managing the portfolio to generate a risk premium.
The Beta of a mutual fund scheme is its volatility relative to its benchmark index.
As the purpose of mutual funds is to outperform the underlying market index, the Treynor Ratio is a useful ratio for examining the scheme’s performance.
‘A’ Fund | ‘B’ Fund | ‘C’ Fund | |
Returns | 17% | 17% | 17% |
Risk Free Rate | 6% | 6% | 6% |
Beta | 1.1 | 0.9 | 0.8 |
Treynor Ratio | 0.10 | 0.12 | 0.14 |
Lower the Beta, Higher the Treynor Ratio.
In the above table, all the schemes have generated similar returns.
However, Fund A’s higher return has come from investing in highly volatile stocks. A Fund with a higher Treynor Ratio is better.
This ratio also helps you to compare different Mutual Fund schemes and you can pick the one most suitable for your risk profile.
6. Portfolio Turnover Ratio
A Mutual Fund scheme is basket of stocks. A Fund manager selects different types of stocks as per the objective of the fund and his expertise. However, it is not a one-time activity. A Fund Manager reviews stocks in a portfolio and buy and sell it according the market conditions and opportunities.
The portfolio turnover ratio is the rate of which stocks in a fund are bought and sold by the fund managers. In simple words, the ratio refers to the percentage (%) change of the assets (stocks in case of Mutual Funds) in a fund over a one-year period.
Where:
- Here securities are stocks in Mutual Fund context. Minimum of securities bought or sold refers to the total amount of new securities purchased or the total amount of securities sold (whichever is less) over a one-year period.
- Average net assets refer to the monthly average amount of net assets in the fund.
Higher Portfolio turnover ratio often mean the scheme is more actively managed, which leads to higher costs and taxes i.e. expense ratio.
7. Expense Ratio
Last one of the seven Ratios. By reading itself, you must have understood the meaning of this ratio. Managing the Mutual fund incurs may expenses. These can be marketing and advertising expenses, administrative expenses, transaction costs, investment management fees, registrar fees, custodian fees, audit fees etc.
All costs for running and managing a mutual fund scheme are collectively referred to as Expense Ratio. It is calculated as a percentage (%) of the Mutual Scheme’s average Net Asset Value (NAV). Investors doesn’t pay anything out of this or her pocket, however, it already reflects in daily NAV of a Mutual Fund Scheme. The daily NAV of a mutual fund is disclosed after deducting the expenses.
Lower the expenses ratio, the better can be the returns generated by the fund. However, this is not the case with every category or every fund.
Equity Category generally has higher expenses ratio as it requires active management and review of the portfolio as compared to Debt Mutual Fund schemes.
At times, the scheme’s performance can justify the higher expenses ratio. Only expenses ratio cannot be the criteria for judging the fund.
Don’t get worried by all the complicated formulas. You don’t have to calculate actually.
All above ratios are readily available on various websites.
Investors just need to know how to interpret them and select a right Mutual Fund scheme.
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