How to Measure Risk in Mutual Funds?

How to Measure Risk in Mutual Funds?

Before investing in any mutual fund it is necessary to do a risk analysis of a mutual fund. Risk in mutual funds can be checked using factors such as Beta, Standard Deviation, Alpha and Sharpe Ratio. These statistical factors can be used to predict risk and volatility before investing in mutual funds. Let us understand all these risk measures in detail and how these statistics help in selecting the best mutual fund for you.

Beta

Beta is a measure of the volatility of a security compared to the market. Beta helps in understanding how much a mutual fund is volatile when compared to its entire market.

A beta of 1.0 means the security is as volatile as the market, Beta of less than 1 means less volatility than the market and beta of more than 1 means more volatility than the market. If a Mutual Fund’s Beta is 1.3 then the fund is 30% more volatile than the market.

Let us Compare some of the Funds of Nippon India Mutual Fund and check their Beta –

How to Measure Risk in Mutual Funds - Beta
Source – Moneycontrol

As seen above Small Cap has a Beta of 0.90, Large Cap has a beta of 1.07 and Index fund has a beta of 0.99. After Comparing Beta’s we can conclude that Nippon India Small Cap Fund is less volatile as compared to its market of Small-Cap Stocks by 10%, Nippon India Large Cap Fund is more volatile than its market of large-cap stocks than 7% and Nippon India Index Fund is exactly as volatile as its market of Index Stocks.

Conservative investors who are looking for stable returns should look for low beta mutual funds and investors who are willing to take more risk for better returns should look for higher beta in mutual funds.

Standard Deviation

Standard Deviation as the name suggests is the deviation of security from its past returns. Higher the standard deviation, higher the volatility compared to its past returns.

In Mutual Funds, Standard Deviation tells us how much returns of the fund will deviate from its past returns. High volatile security would have a higher standard deviation. For Ex. If a fund has a deviation of 3 and its past returns are 12% than the expected returns from the fund would be 3% more or less than its benchmark returns which is either 9% or 15%.

Let us again compare the same funds as above and check their Standard Deviation –

How to Measure Risk in Mutual Funds - Standard Deviation
Source – Moneycontrol

As shown above, Standard Deviation of Small Cap fund is 14.64, Large Cap is 14.03 and Index fund is 12.01. These SD’s determine how much more returns potential the fund has as compared to its past returns performance.

Conservative Investors should look for low Standard Deviation funds and Aggressive Investors looking for better returns should look for high Standard Deviation in Mutual funds.

Alpha

Alpha indicates how much additional return fund can generate in comparison to its benchmark. If a fund has an alpha of 2 and its benchmark is Nifty50, this indicates the fund has beaten Nifty50 returns by 2%

So Higher the Alpha, the better returns than the benchmark. So Investors should always look for high Alpha in mutual funds.

Let us again compare the same funds as above and check their Alpha –

How to Measure Risk in Mutual Funds - Alpha
Source – Moneycontrol

As we can see Small Cap fund has a negative alpha of -2.63 which means Small Cap fund has underperformed its benchmark by -2.63%, Large Cap fund has -0.69 Alpha which means Large Cap has also underperformed its benchmark by -0.69% & Index fund has an Alpha of 0.26 which means Index fund can get 0.26% more returns than its benchmark.

Sharpe Ratio

Sharpe Ratio indicates how much excess return was generated for each unit of risk taken. It Considers how much extra return was generated for extra risk taken.

It is calculated by subtracting the risk-free return, defined as an Indian Government Bond, from the fund’s returns, and then dividing by the beta of returns. A higher Sharpe Ratio shows better risk-adjusted returns for the investor.

For Ex. If Returns of Fund A & B are 15% each but Fund A has a Sharpe Ratio of 0.71 and Fund B has a Sharpe Ratio of 0.52, then you should select Fund A as it has higher Sharpe Ratio.

How to Measure Risk in Mutual Funds - Sharpe Ratio
Source – Moneycontrol

As we see in the Above Image, Small Cap Fund has a Sharpe Ratio of 0.30, Large Cap of 0.58 and Index Fund of 0.71. We can conclude that the Index Fund has better risk-adjusted returns than Small Cap and Large Cap.

Investors when Comparing to funds with Similar returns should select the fund which has better Sharpe Ratio.

Summary

Let us Conclude All these Statistical Factors and Summarise them –

1) Beta is a comparison between the volatility of the Security and the market.

2) Standard Deviation is the deviation of returns from its past performance.

3) Alpha is the extra returns generated by the security than its benchmark.

4) Sharpe Ratio is the Extra Return received for an extra unit of risk taken.

Also Read – How to Invest in Mutual Funds.

Hope you can understand the various measures of risk in mutual funds, If you have any questions do let us know in the Comments Section Below & Thank You very much for reading.

1 thought on “How to Measure Risk in Mutual Funds?”

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