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Mutual Fund – Risk Ratios

While investing in Mutual Fund, most of the people tend to stress on returns, but it’s equally important to consider the risk ratios too. Here’s a simple explanations which will help you to decipher the meaning of this ratios.

Alpha: It’s a measure of an investment’s performance on a risk-adjusted basis. It takes the volatility (price risk) of a fund portfolio and compares its risk-adjusted performance to a benchmark index. The excess return of the investment relative to the return of the benchmark index is its “alpha”.

simply stated, alpha is often considered to represent the value that a portfolio manager adds or subtracts from a fund portfolio’s return. A positive alpha of 1.0 means the fund has outperformed its benchmark index by 1%. Correspondingly, a similar negative alpha would indicate an under performance of 1%. For investors, the more positive an alpha is, the better it is.

Beta: Also known as the “beta coefficient,” is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole. Beta is calculated using regression analysis, and you can think of it as the tendency of an investment’s return to respond to swings in the market. By definition, the market has a beta of 1.0. Portfolio values are measured according to how they deviate from the market.

A beta of 1.0 indicates that the investment’s price will move in lock-step with the market. A beta of less than 1.0 indicates that the investment will be less volatile than the market, and, correspondingly, a beta of more than 1.0 indicates that the investment’s price will be more volatile than the market. For example, if a fund portfolio’s beta is 1.2, it’s theoretically 20% more volatile than the market.

Conservative investors looking to preserve capital should focus on fund portfolios with low betas, whereas those investors willing to take on more risk in search of higher returns should look for high beta investments.

R-Squared: It’s a statistical measure that represents the percentage of a fund portfolio’s movements that can be explained by movements in a benchmark index.

R-squared values range from 0 to 100. Its said that, a mutual fund with an R-squared value between 85 and 100 has a performance record that is closely correlated to the index. A fund rated 70 or less would not perform like the index.

Mutual fund investors should avoid actively managed funds with high R-squared ratios, which are generally criticized by analysts as being “closet” index funds. In these cases, why pay the higher fees for so-called professional management when you can get the same or better results from an index fund?

Standard Deviation: It measures the dispersion of data from its mean. In plain English, the more that data is spread apart, the higher the difference is from the norm. In finance, standard deviation is applied to the annual rate of return of an investment to measure its volatility (risk). A volatile would have a high standard deviation. With mutual funds, the standard deviation tells us how much the return on a fund is deviating from the expected returns based on its historical performance.

Sharpe Ratio: Developed by Nobel laureate economist William Sharpe, this ratio measures risk-adjusted performance. It is calculated by subtracting the risk-free rate of return (Government Bond) from the rate of return for an investment and dividing the result by the investment’s standard deviation of its return.

The Sharpe ratio tells investors whether an investment’s returns are due to smart investment decisions or the result of excess risk. This measurement is very useful because although one portfolio can reap higher returns than its peers, it is only a good investment if those higher returns do not come with too much additional risk. The greater an investment’s Sharpe ratio, the better its risk-adjusted performance.

You can check out through wikipedia, for more elaborate understanding 🙂