How to measure mutual funds risk

To measure mutual fund risk, investors typically assess metrics such as standard deviation, beta, and Sharpe ratio to gauge volatility, sensitivity to market movements, and risk-adjusted returns respectively.
Measure mutual funds risk
3 min
04-June-2024

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.

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Benefits of measuring mutual fund risks

Measuring mutual fund risks is both crucial and beneficial to investors for various reasons. They include:

  • Insights into fund performance: Risk metrics like the standard deviation, alpha, beta and R-squared can give you insights into how volatile a fund is and how much it is influenced by market movements.
  • Fund comparison: By measuring the risks of different mutual funds, you can figure out how they compare against one another. This makes it easier to select funds that align with your risk-return preferences.
  • Effective diversification: Once you identify the risk levels of different mutual funds, you can use this data to diversify your portfolio effectively by balancing high-risk and low-risk funds to optimise returns.
  • Informed investment decisions: Above all, measuring mutual fund risk helps you make informed decisions and choose funds that match your risk tolerance levels.

Mutual fund risk ratings

Most mutual fund houses offer insights into the risk of the schemes they offer, so you can check these details before you invest. You can find the details of mutual fund risk measures displayed as a riskometre on the front page of a New Fund Offer (NFO) application form, the Key Information Memorandum (KIM) or the Scheme Information Document (SID).

Conclusion

With this, we come to the end of this article on risk measures in mutual funds. You can find the mutual fund risk ratings available on the official website of the Asset Management Company (AMC) or the stockbroking firm through which you have invested. Alternatively, you can also use the measures outlined above to find out how risky a fund is before investing.

If you want to browse through different schemes and compare mutual funds before making an informed choice, check out the 1,000+ options available on the Bajaj Finserv Mutual Fund Platform. You can easily find a fund that aligns with your risk tolerance levels and investment horizon, making it a suitable fit for your investment portfolio.

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Frequently asked questions

How can I check the risk profile of a mutual fund?
You can look up the mutual fund’s risk rating on the website of the mutual fund house or on any other financial data aggregation platform to understand how risky a fund is.
How to calculate the risk of a mutual fund?
To quantify the risk of a mutual fund, you can use different mutual fund risk measures like the standard deviation, Sharpe ratio, Sortino ratio and beta.
What are the different methods of measuring investment risk?
Some of the common methods of measuring investment risk include checking the volatility, beta, Value at Risk (VaR), alpha and Sharpe and Sortino ratios of the asset.
What is the best indicator of a mutual fund’s performance?
There are many good ways to quantify the success of a mutual fund’s performance. You can check the fund’s alpha, beta, total returns, and drawdown. You can also compare it to a benchmark.
Which colour in a riskometre indicates high levels of risk in mutual funds?
Generally, the colour red is used to denote high levels of risk in a mutual fund scheme. However, some riskometres use labels like low, moderate and high instead of colours to denote risk.
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Disclaimer

Bajaj Finance Limited (“BFL”) is an NBFC offering loans, deposits and third-party wealth management products.

The information contained in this article is for general informational purposes only and does not constitute any financial advice. The content herein has been prepared by BFL on the basis of publicly available information, internal sources and other third-party sources believed to be reliable. However, BFL cannot guarantee the accuracy of such information, assure its completeness, or warrant such information will not be changed. 

This information should not be relied upon as the sole basis for any investment decisions. Hence, User is advised to independently exercise diligence by verifying complete information, including by consulting independent financial experts, if any, and the investor shall be the sole owner of the decision taken, if any, about suitability of the same.