Before you make any investment, it is important to understand the level of risk it brings to your portfolio. Broadly, you may be aware that some investments are riskier than others. For instance, you may know that equity mutual funds carry more risk than debt funds. However, to figure out if a mutual fund aligns with your risk preferences, you need to have a clearer insight into its risk profile. Here is where mutual fund risk measures can help.
In this article, we explore the different types of risks in mutual funds, see how you can quantify this risk and understand mutual fund risk ratings.
Overview of mutual fund risks
Mutual Funds are complex investments that carry different types of risks. Market-linked funds like equity-oriented schemes carry market risk because the returns from the funds depend on the market’s performance. Many schemes like sectoral funds and market cap-oriented funds also have concentration risk.
Debt-oriented mutual funds are vulnerable to interest rate risks. Additionally, some schemes may also come with liquidity risks and credit risks. You can avoid credit risk by checking mutual fund risk ratings before you invest. However, it is always advisable to look into the different mutual fund risk measures to understand the risk profile of a scheme thoroughly before you add it to your portfolio.
How to measure mutual fund risk
There are many ways that you can use to check how risky or risk-free a mutual fund is. Here is an overview of some common risk measures in mutual fund evaluation.
- Beta
The beta or beta coefficient is one of the simplest and most effective mutual fund risk measures you can use. It measures how volatile a fund is when compared with its benchmark. A fund with a beta of 1 is as volatile as its benchmark. If the beta is more than 1, the fund is more volatile than the benchmark (and vice versa). Here low beta equals low volatility equals low risk. - Alpha
The alpha measures the excess returns from a mutual fund scheme in comparison to its benchmark. A modified version of this metric, known as Jensen’s alpha, measures the risk-adjusted performance of a fund by taking the scheme’s beta into account. The higher the Jensen’s alpha, the more the risk-adjusted returns from the mutual fund have historically been. - R-Squared
The R-squared value of a mutual fund tells you how much of the fund’s movements can be traced back to fluctuations in its benchmark index. The value of this metric can range from 0 to 100. If the R-squared is 100, it means the fund’s volatility can be entirely explained by the benchmark. Conversely, if the value is 0, it means that the fund’s performance cannot be correlated with its benchmark at all. - Standard deviation
The standard deviation of a mutual fund’s performance measures how much its returns deviate from its average levels. For instance, say, a mutual fund scheme has an average return of 13% per annum and a standard deviation of 2%. This means you can expect the returns to be +/- 2% on either side, ranging from 11% to 15%. The higher the standard deviation, the greater the volatility in the fund’s returns will be and, therefore, the higher the risk. - Sharpe ratio
The Sharpe ratio tells you what the risk-adjusted returns from mutual funds are. By checking this ratio, you can understand how much excess returns you earn for each unit of risk or volatility that the fund brings to your portfolio. To calculate the Sharpe ratio, you need to divide the excess returns from a fund (over and above the risk-free rate) by the fund’s standard deviation. - Sortino ratio
The Sortino ratio is very similar to the Sharpe ratio. The main difference is that this ratio only takes into account the harmful or negative volatility in a mutual fund. This is because positive or favourable volatility has the effect of boosting your returns, which is why it is not really a risk. To calculate the Sortino ratio, you must divide the excess returns from a fund (over and above the risk-free rate) by its negative standard deviation alone.
