What are the Different Ways to Measure Mutual Fund Risks?
It is an open secret that mutual fund investments carry some risks. Risks involved in mutual funds can vary depending on the fund. For example, while an equity fund carries market risks, sectoral funds carry concentration risk. Similarly, debt funds are subject to interest rates and credit risks. Risk in mutual fund investment is a culmination of several factors.
As an investor, it is crucial for you to be aware of the risks in mutual fund investment. The good news is that there are several ways through which you can measure them.
Important metrics to help you gauge mutual funds risk
Mutual funds’ risk factors emanate from various sources. Changes in the economy, interest rates, geo-political situation, company management, etc., all contribute to mutual funds’ risk. This risk, however, is measurable while analysing and selecting funds. Some ways to do so are:
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Beta
Beta helps measure a fund's relative volatility against its benchmark. It indicates how likely a fund is to experience a wide swing in value. Always benchmarked to 1, if a fund's beta is less than 1, it is less sensitive to the benchmark.
On the other hand, if it is more than 1, it indicates more sensitivity. If a fund's beta is 1, it is likely to move in line with the benchmark or market. If you have a conservative outlook, you can opt for a fund with low beta and vice versa.
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R-squared
R-squared helps measure a fund's correlation to its benchmark performance on a scale of 100. A fund’s R-squared value gives an idea of its performance relative to the overall market.
A higher value shows that the fund's performance is close to the benchmark index. You can use it to select a fund. For instance, if an active fund has a very high R-Squared value, you can contemplate replacing it with an index fund which has a comparatively lower expense ratio.
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Standard deviation
Standard deviation helps measure a fund's volatility around its average returns. To put it otherwise, it shows how much a fund's return could deviate from the average return. Let's understand it with an example.
Suppose a fund has an average annual return of 13% per annum and a standard deviation of 2%. This means the fund's return could deviate + or -2% on either side and range from 11% to 15%. The higher the standard deviation, the greater the volatility.
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Sharpe ratio
The Sharpe ratio helps you understand whether a fund's returns are due to prudent investment decisions of the fund manager or a result of excessive risk. This ratio is helpful while comparing multiple funds to find out the one offering better risk-adjusted returns.
This ratio is arrived at by subtracting a fund's risk-free return from its return and dividing the result by the standard deviation. The table helps you better understand it.
| Particulars | Mutual Fund A | Mutual Fund B |
|---|---|---|
Fund’s return | 15% | 12% |
Risk-free return | 5% | 5% |
Standard deviation | 11% | 6% |
Sharpe ratio | 0.91 | 1.17 |
While mutual fund A has delivered more returns than fund B, the latter has given better risk-adjusted returns.
Wrapping it up
You will find these key metrics in a fund’s documentation and factsheet. Go through them carefully and choose a fund that best aligns with your risk tolerance. Remember, mutual funds risk and return go hand-in-hand, and no single metric can provide a complete picture of a fund’s actual risk. Factor in multiple metrics to select a fund whose risk matches your preference.
Disclaimer: This article is for informational purposes only and does not constitute financial advice. It is not produced by the desk of the Kotak Securities Research Team, nor is it a report published by the Kotak Securities Research Team. The information presented is compiled from several secondary sources available on the internet and may change over time. Investors should conduct their research and consult with financial professionals before making any investment decisions. Read the full disclaimer here.
Investments in the securities market are subject to market risks, read all the related documents carefully before investing. Please read the SEBI-prescribed Combined Risk Disclosure Document before investing. Brokerage will not exceed SEBI’s prescribed limit.
