| July 09
Significance of ratios for mutual funds
Here, is the mean of returns, n is the number of
returns, and x refers to each individual return. The operator denotes sum. Thus, to calculate
standard deviation we subtract each return from its mean, square the deviations
and sum them up. Then we divide them by the total number of returns less one,
and square root the result. Let’s understand why we use standard deviation.
deviation is a measure of the distribution of a dataset in relation to its
mean. Since all funds provide us with mean returns over a period, standard
deviation is helpful in measuring the volatility of a fund. A higher standard
deviation indicates that the fund’s price tends to fluctuate more, indicating
unpredictability of returns. This unpredictability is taken as a proxy for risk
in the market, making standard deviation an important metric to judge riskiness
is important to note that high or low standard deviation does not necessarily
make a good or bad investment. All else constant, lower standard deviation
indicates greater consistency of returns, but people who have a higher risk
appetite might choose to go with funds that have slightly higher standard
deviations. The choice depends entirely on the risk profile of the investor.
Also, it must be kept in mind that standard deviation must not be studied in
isolation. Because it measures volatility around the mean returns, studying the
mean returns themselves is also important before picking the mutual fund that
is right for you.
purpose of the Sharpe ratio is to provide a measure that integrates risk and
return. By adjusting the portfolio’s excess returns by its standard deviation,
it essentially measures the returns a fund can generate for every unit of risk
that it takes. A higher Sharpe Ratio is always desirable as it indicates that
the fund is generating higher returns by taking lower risk.
important measure of risk is the Beta of a mutual fund.
it is calculated by dividing the covariance of a portfolio’s returns with the
market/benchmark returns, divided by the variance of the market/benchmark
purpose of beta is to track the volatility of your investment with relation to
the market. The beta is centered around 1 as the market has a beta of 1. Thus,
a portfolio with a beta higher than 1 is more volatile than the average market,
while a beta lesser than 1 indicates lower-than-market volatility. Let’s take
an example. Suppose a mutual fund has a beta of 1.15. This indicates that for
every 1 point of deviation in the market, we expect the mutual fund’s value to
change by 1.15 points. Thus, it is a fund which is riskier than the market.
like standard deviation, we cannot establish a thumb rule as to whether a high
or low beta is desirable. The beta is merely a measure of risk. Higher betas
raise the expected return of an investment as the fund manager is taking on
more risk, while lower betas indicate safer investments.
final ratio we will discuss is alpha.
measures the excess returns a fund is generating as compared to its expected
return, based on its beta. For example, an alpha of 3% indicates that the fund
is generating 3% more returns than it is expected to, based on the riskiness of
its investments. It is taken as a valuable measure of the quality of a fund and
particularly its fund manager. We look for higher alphas as they indicate that
the fund can generate market-beating returns.
investors must keep in mind that ratios must be tracked over time. Consistency
across them is important. For example, a fund with a positive alpha currently
but with negative alphas in previous periods is something that must be treated
with caution. So go ahead, study the ratios of your mutual funds, and decide
what’s best for you based on your own risk profile.