6 Important Ways To Measure Risk in Mutual Funds
Mutual funds are marketable securities and like any other investment options, different mutual fund types come with different risks, including volatility, liquidity, and interest rate risks. While these risks are unavoidable, you can still check whether a mutual fund is able to deliver superior performance when compared to the risk involved. Here are some key mutual fund risk measures that you can check to see how risky the fund is and how fruitful your investment will be.
6 Important Ratios To Measure Risk in Mutual Funds
The beta coefficient is a risk measure that estimates the volatility of a mutual fund against its benchmark. Hence, beta in a mutual fund measures the relative risk and not the actual risk involved. The beta value ranges from zero to infinity. If the beta in a mutual fund is one, it means the risk in a mutual fund will move in tandem with the benchmark. If it is below one and above zero, it means the risk involved is lesser than the benchmark, whereas if beta is above 1, it means the risk involved is higher than the benchmark.
Alpha, although it isn't a risk measure, is used along with beta to measure the mutual fund's performance against its benchmark. A positive alpha in a mutual fund indicates that the fund has delivered superior performance in comparison to its benchmark. It indicates the fund manager's ability to deliver superior returns. In contrast, a negative alpha in a mutual fund indicates the fund's returns are lower than its benchmark, indicating that the fund manager isn't capable of delivering high returns. It is important to note that alpha is calculated based on historical data and doesn't guarantee future performance.
R-squared, a popular statistical ratio that measures correlation, is also one of the most useful mutual fund ratios that measure risk. It measures the percentage of mutual fund portfolio movements that can be explained by benchmark index movements. The value of the R-squared ranges from 0-100, and if the R-squared is between 70-100, it means there is a good correlation between the mutual fund and the benchmark. If the value of R-squared is between 40 and 70, it has an average correlation, and if it's below 40, it has a low correlation. R-squared is very useful in fund selection. For example, if the R-squared of a mutual fund is high, it means it’s performance is similar to that of an index fund, and hence, it is better to choose an index fund over this mutual fund as the expenses will be less.
Standard deviation is a popular statistical ratio that measures the volatility or deviation of a mutual fund's return from its average return. A high standard deviation indicates the fund's returns fluctuate a lot with a wider gap from the average. This indicates there are periods where the fund gave higher profits but also significant losses to the investors. On the other hand, a high standard deviation indicates that the returns are closer to the average return of the fund and have lower volatility. Usually, people who are risk averse can prefer funds with low standard deviation, and people who have high-risk tolerance can prefer funds with high standard deviation.
Sharpe ratio measures the risk-adjusted returns of an investment. It uses the standard deviation of a fund to calculate how well the fund has performed above the risk-free return, such as return from government securities. A high Sharpe ratio of a mutual fund indicates better risk-adjusted returns, indicating investors are compensated well for the risk taken. The high Sharpe ratio also indicates that the fund's returns are due to wise investment decisions rather than excessive risk taken. A low ratio, on the other hand, indicates that the fund doesn't compensate well for the risk undertaken by the investor.
The Sortino ratio is similar to the Sharpe ratio. However, it primarily focuses on the downside risk in a mutual fund. In other words, it measures the risk-adjusted returns using a negative standard deviation. The Sortino ratio is a better measure of risk as it tells how much risk is involved in a mutual fund. Sharpe ratio also takes into consideration the positive volatility, which can boost the returns of a fund. However, the Sortino ratio measures the risk-adjusted returns solely through the negative volatility. A high Sortino ratio in a mutual fund indicates the lesser impact of downside deviation on the returns.
There are several mutual funds available in the market, making the selection slightly tricky. Hence, you can use these risk assessment ratios to filter out the funds that best suits your mutual fund portfolio. If you are a risk-averse investor, you may prefer funds with low beta, low standard deviation and high Sortino ratio. In contrast, if you have high-risk tolerance levels, then you may choose funds with high alpha and Sharpe ratio.