MEASURING RISK- MUTUAL FUNDS

Risk associated with mutual funds’ returns can be measured through two methods. Standard Deviation and Sharpe ratio.

Fluctuation in a mutual fund’s (MF) returns point to the risk. This may be caused by factors that are specific to the securities included in the portfolio or the risks by macro factors that affect all securities as well as portfolios and cannot be eliminated. The total risk in a MF, caused by these factors, is measured by Standard Deviation.

STANDARD DEVIATION (SD). This is a measure of how the MF’s actual performance strays from the average returns over a period. In other words, it is a measure of the consistency of an MF’s returns. A higher SD number indicates that the net asset value (NAV) of the MF is more volatile and, hence, it is riskier than a fund with a lower SD.

There are certain caveats in using the SD number to evaluate an MF as it gives an estimation of risk only when it is seen in conjunction with its peer group. A SD of 24 for an MF gives no information of its risk unless the investor knows that other MFs in the category have standard deviations of only 20. The investor would then consider the MF with the higher SD as being riskier. The other issue is that it rewards consistency irrespective of whether gains have been made or losses. So, an MF that gives negative returns consistently will have a lower SD as compared to a one that gives positive but fluctuation returns.

SHARPE RATIO (SR)

This is a measure of the risk adjusted return of a MF. It evaluates the return that it has generated relative to the risk taken. An MF with a higher SR is better simply because it implies that it has generated higher returns for every unit of risk that was actually taken by it. Calculation of SR is taken as the free rate of return such as the 90-day Treasury bill. Risk here is measured by SD.

As with SD, SR suffers from the drawback of being a relative measure. It gives no meaningful information on its own, but it is useful to rank and compare MFs that are being evaluated for investment. The use of SD may distort the ratio. An MF with low or negative, but consistent, returns will have a low SD and a high SR.

The evaluation, however, is complete only if qualitative factors such as portfolio composition, consistency in investment objectives and strategy are also considered.