Investing in a mutual fund scheme is not everyone’s cup of tea as it requires proper due diligence on the part of the investors while selecting any scheme.
Though it is true that you cannot predict a future winner but at least you can track the past performance of the mutual fund scheme to draw some inference out of it.
In this blog, we are going to talk about 5 ratios which an investor should look for before selecting any mutual fund scheme.
Simply put, this ratio tells an investor how much extra return the fund is able to generate over market returns.
The risk-adjusted performance of the scheme is compared with that of the benchmark index and the difference between the two is considered as the alpha.
In other words, we can say that it shows the performance of the fund manager in handling the scheme. Higher the alpha the better it is.
For example, an alpha of 1.0 means that the fund has outperformed the benchmark index by 1 % and an alpha of -1.0 indicates that the fund has underperformed its benchmark index by 1%.
Beta coefficient or beta is also known as systematic risk is basically a measure of the volatility of a security or a portfolio compared to the market as a whole.
In other words, beta represents the relation between the market returns and the portfolio returns. By definition, the market has a beta of 1.
Suppose a portfolio has a beta of 2.0, then if the markets rose by 5% then the scheme will generate 10% in returns.
But if the beta of the scheme is -2.0, then even if the markets generate 5% positive returns the scheme will generate 10% negative returns.
Higher the beta the more volatile will be the investments.
It is the statistical measure which generally represents the portion of the portfolio that is influenced by the benchmark index movement. The value of R-squared usually ranges from 0 to 100.
The performance of a fund with an R-squared value between 85-100 will almost be similar to the index.
The financial experts believe that the investors will be better off investing in index funds than investing in a fund with an R- squared value between 85-100 because the results will be almost identical and hence there is no point in paying more for the later.
For example, if a stock or fund has an R-squared value of close to 100%, but has a beta below 1, it is most likely to offer higher risk-adjusted returns.
It can be defined as the deviation from the mean return or average return. In financial terms, we can define it as the deviation of the annual returns from the average returns of say last 10 years.
The more the deviation the more will be the volatility of the fund. A fund with less standard deviation is considered to be a consistent performer and should be preferred over a fund with more standard deviation.
Generally, large-cap funds have less standard deviation than mid-cap or small-cap funds.
Sharpe ratio shows the risk-adjusted performance of a fund. It shows the return per unit of risk taken.
This ratio is calculated by subtracting the risk-free rate of return (usually the rate of 10 years G-secs) from the returns generated by the portfolio and then dividing it by the standard deviation.
The significance of this ratio is that it tells an investor whether the extra return generated by the scheme is due to the better investment strategy adopted by the fund manager or due to the extra risk taken.
Higher the Sharpe ratio the better it is as it shows the better risk-adjusted performance of a fund.
Further Reading: Mutual Fund Sahi Hai
Treynor ratio is also a measure of excess return earned per unit of risk.
The numerator remains the same as it is in case of Sharpe ratio i.e. (Rm-Rf) but instead of standard deviation in the denominator, this ratio uses Beta.
In essence, the Treynor ratio is a risk-adjusted measurement of return based on the systematic risk.
Higher the ratio the better it is as it indicates the return an investment earned for the amount of risk taken.
When to use Sharpe Ratio or Treynor Ratio
As stated earlier, the Sharpe ratio uses standard deviation while the Treynor ratio uses Beta as the denominator. Standard deviation measures the total risk of the portfolio while Beta represents a systematic risk.
Systematic risks are basically uncontrollable factors like inflation, interest rates, government policies, etc. while on the other hand, unsystematic risk is specific to a particular company or industry.
Hence, the Sharpe ratio is a good measure when the portfolio is not diversified while Treynor is a better measure when the portfolio is well diversified.
The onus of diversification is on the fund manager who adopts all strategies to avoid the overall risk of the scheme’s portfolio.
Hence, a fund manager controls unsystematic risk through his/her due diligence and only systematic risk is left out which can be ideally measured by Treynor ratio.
These ratios only help an investor in choosing a better scheme which does not guarantee future returns from a fund.
Also before jumping on analyzing any fund an investor should consider other important factors like time horizon, income needs, goals, etc. for optimum results.
These ratios should not be used in isolation as it may present a different picture.
If you want to skip this process and want to invest without any fuss then you may consider hiring a financial advisor.
Further Reading: Business Today