Mutual funds vary in terms of risk, potential returns and overall performance. These aspects depend on various factors like the type of fund, the general market conditions, the expertise of the fund manager and other such aspects. To evaluate the performance of a fund, you can rely on various mutual fund ratios and metrics like the alpha, beta, Treynor ratio, Sharpe ratio and more.
In this article, we explore what mutual fund ratios are, why they matter and which mutual fund ratios you can use to evaluate mutual fund performance.
What are mutual fund ratios?
Mutual fund ratios are mathematical tools that compare and assess different aspects of mutual fund schemes. They can help you evaluate how risky a mutual fund scheme is, how volatile its returns are likely to be and even how well or poorly the fund has performed relative to other similar funds or a benchmark.
Important Mutual Fund Ratios
To evaluate mutual fund performance comprehensively, you can use a mix of the following key mutual fund ratios.
Alpha
The alpha of a mutual fund is a measure of its performance relative to a benchmark or an index. It is one of the five key risk ratios used in Modern Portfolio Theory (MPT). It is either represented as an absolute value or a percentage. An alpha value of 0 means that a fund has performed the same as its benchmark. An alpha value of over 0 means the fund has outperformed its benchmark, while a value less than 0 means it has underperformed.
For instance, say a fund has delivered 12% returns in the last year. Over the same period, its benchmark index has delivered 16%. This means the fund has underperformed by 4%, so its alpha will be —4.
To make this mutual fund ratio more accurate, you can use Jensen’s alpha (which factors in the risk as well) instead of the standard alpha. The formula for this mutual fund ratios is shown below:
Jensen’s alpha = Fund rate of returns – Risk-free rate of returns – Beta x (Market returns – Risk-free rate of returns)
Standard Deviation (SD)
The standard deviation of a mutual fund gives you insights into how much its returns fluctuate from the fund’s average or mean returns. A high standard deviation indicates that the fund is extremely volatile, while a low SD points to a relatively stable fund.
Beta
The beta is a mutual fund ratio that helps you measure its systematic risk — or the risk that is linked to the broad market. In other words, this ratio tells you how sensitive or volatile a mutual fund portfolio is when compared to the broad market market moment. It is represented as a whole number and can be positive or negative.
The formula for a fund’s beta is:
Beta = (Covariance of the fund’s returns with the market returns) ÷ Variance of the market return
If the beta is 1, it means the fund is exactly as volatile as the market. If the beta is more than 1, the fund is more volatile than the market, and if it is less than 1, it means the fund is less volatile than the market. A negative beta means that the fund’s value moves in the opposite direction to the market’s movement.
Treynor ratio
The Treynor ratio measures the excess returns you get from a mutual fund for every unit of risk (or beta) you take on by investing in the fund.
The formula for this mutual fund ratio is:
Treynor Ratio = (Fund returns — Risk-free rate) ÷ Fund’s beta
This ratio essentially tells you what your risk-adjusted returns are. So, the higher the Treynor ratio, the better the fund’s returns could be.
Sharpe ratio
The Sharpe ratio is another mutual fund ratio that can help you calculate the risk-adjusted returns of a fund. However, unlike the Treynor ratio, the Sharpe ratio uses the standard deviation of the mutual fund as the denominator.
This gives us the following formula:
Sharpe ratio = (Fund returns — Risk-free rate) ÷ Fund’s standard deviation
A higher Sharpe ratio is generally preferred, especially for highly volatile mutual funds. This is because a high Sharpe ratio indicates that the excess returns from the fund justify the risk of the additional volatility in the fund.
Why are Mutual Fund Ratios Important?
These ratios are important because they give you insights into what you can expect from a mutual fund portfolio. With the right mutual fund ratios, you can determine if a fund’s risk-reward profile aligns with your risk-reward preferences. Additionally, these ratios are also helpful if you want to compare mutual funds and select the right scheme for your financial goals.
Conclusion
Different mutual fund ratios offer different insights into the risk, returns and overall performance of a mutual fund. If you are wondering how to choose mutual funds that align with your risk-reward preferences, you need to look into all the ratios outlined above comprehensively.
You can then invest in the funds of your choice directly and easily through the Bajaj Finserv Mutual Fund Platform. Here, you can evaluate and compare over 1,000 mutual funds and find the scheme that is the right fit for your portfolio.
