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Mutual Funds Indicators

How to Measure Mutual Fund Risk | Alpha, Beta, SD, Sharpe, R-squared, Sortino | Learn with ETMONEY

BETA​

Beta - Measurement of risk or volatility

Beta is a commonly used risk measure and calculates the relative volatility of a stock or mutual fund's returns as against its benchmark. the beta merely explains the relative riskiness of an asset and does not give us the inherent risk of the asset itself.

As an investor, you can use this information on the beta to align your mutual fund portfolio according to your risk appetite. For instance, if you are a conservative investor, you might want to focus on low beta portfolios. But remember what we said earlier beta is a relative measure and does not give us the inherent risk of an asset.

ALPHA​

Alpha - Excess return above the benchmark

Alpha quite simply measures how much better a fund has performed as compared to its benchmark index.

For instance, if the Nifty 50 delivered 10% this past year and your fund did 11% .. then the alpha is +1%. And if your fund underperformed and achieved only 8% .. then the alpha is -2%. This means actively managed funds can have positive or negative alpha depending on how well the fund manager runs the fund. In fact, creating positive alpha is the entire essence behind someone investing in an actively managed fund

Alpha is not an excess return! Alpha is excess return calculated on a risk-adjusted basis.

  • Jensen's alpha = (excess return of index wrt risk-free instrument) -- (a measure of relative volatility wrt nifty 50) x (excess market return wrt risk-free instrument)
  • the excess return of index wrt risk-free instrument = index return -- MIBOR return
  • the excess return of market -- nifty 50 -- wrt risk-free instrument = nifty 50 return -- MIBOR return.
  • relative volatility wrt nifty 50 = beta.
  • Alpha = (Stock return -- risk-free return) -- (Benchmark return -- risk-free return) x beta

Alpha factors in how volatile a fund has been compared to the market. A stock/fund that beats the market but is more volatile than the market in doing so will have lower alpha than a fund with lower volatility. Thus even funds with no excess returns can "produce an alpha".

Jensen's Measure / Jensen's Alpha​

The Jensen's measure, or Jensen's alpha, is a risk-adjusted performance measure that represents the average return on a portfolio or investment, above or below that predicted by the capital asset pricing model (CAPM), given the portfolio's or investment's beta and the average market return. This metric is also commonly referred to as simply alpha.

  • The Jensen's measure is the difference in how much a person returns vs. the overall market.
  • Jensen's measure is commonly referred to as alpha. When a manager outperforms the market concurrent to risk, they have "delivered alpha" to their clients.
  • The measure accounts for the risk-free rate of return for the time period.

https://www.investopedia.com/terms/j/jensensmeasure.asp

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R-SQUARED​

The R-Squared aims to measure a fund's correlation to its benchmark performance. This is done on a scale of 100 which means if the R-Squared is a 100 then it shows that the performance of the mutual fund is perfectly correlated with the performance of the benchmark

This particularly the case when it comes to index funds that have an R-Squared of 99 or 100. On the other end, we typically see actively managed mutual funds which can have a range of R-squared values

STANDARD DEVIATION​

The standard deviation measures the dispersion of data from its mean and from a mutual fund perspective, it represents the volatility or riskiness of the fund. For instance, let's say a mutual fund delivers 10% average returns over a period of time. But as expected, this fund has had some good months and also some bad months with returns vacillating between +20% and -15%

This up and down trajectory of returns in the mutual fund NAV is what standard deviation captures and presents as an annualized number

SHARPE RATIO​

The Sharpe ratio measures risk-adjusted performance and is calculated by subtracting the risk-free rate of return from the fund's returns and then dividing the result by the standard deviation. In other words, the Sharpe ratio indicates whether a mutual fund's returns are due to the wise investment decisions taken by the fund manager or was it the result of taking excessive risk

Like many statistical tools, the Sharpe ratio too can lead to some misleading inferences if used in isolation. For example, it's commonly possible that a fund with low returns and low standard deviation might show a high Sharpe ratio

Mutual Fund Risk Measures Explained: Sharpe Ratio

SORTINO RATIO​

The Sharpe ratio uses the total volatility in its calculations in the form of standard deviation. This is where the Sortino ratio is different as it only uses only the fund's downside standard deviation in its calculations

So as a formula, the Sortino ratio is much like the Sharpe Ratio subtracts the risk-free returns from the fund returns but instead of dividing it by the total standard deviation .. it divides the difference with the downside deviation

This ratio is particularly useful for risk-averse or conservative investors and in the real sense, determines the success of a fund in capping its downside volatility. The Sortino ratio is a useful way for all kinds of investors, analysts and portfolio managers to evaluate a fund's return for a given level of bad risk.

Thumb rule way of remembering​

  • A high Alpha, a high Sharpe ratio and a high Sortino indicate better potential performance for a fund
  • A low Beta and a low standard deviation indicates lower volatility for the fund
  • A higher R-Squared indicates a better correlation with the benchmark
  • Max Alpha with minimum beta

Important mutual fund metrics when picking mutual funds - YouTube

Since past performance doesn't dictate future returns, why not buy MF NFOs?