Investing in mutual funds and regularly monitoring their performance is the commonly recommended mantra among investors. Regular monitoring often delves into looking at the Net Asset Value of the mutual fund and how it has increased since your investment. One may also look into the performance of peer schemes and assess the risk involved in your present mutual fund investment. However, you can look beyond these and use a few simple tips to measure the risk on your mutual funds.
Beta – Beta is a commonly used risk marker to measure the volatility of a stock or mutual fund against its benchmark. It is a relative measure and assumes the beta of the underlying index as 1. It measures the sensitivity of the mutual fund to changes in the underlying index. A gold ETF fund, let’s say, must have a relation to the price of gold. The closer its changes are with the changes in the gold price, the lower its beta will be. Safer fund options will have a lower beta. While you should look into the beta of your mutual fund, it is not the only parameter for investing or holding.
Alpha – Alpha is the comparison of return between a mutual fund and its benchmark. If the benchmark had a return of 5% while the mutual fund had 7%, the alpha of the mutual fund is 2%. In the reverse scenario, the alpha would be -2%. If you invest in actively managed mutual funds, you will have to see variations in the alpha of the scheme. The further it is from zero, the higher are the risks involved. Passive funds like index funds will have a negligible alpha.
R-squared – It is a statistical measure ranging from 0 to 100. The closer a fund scheme is to 100, the higher its correlation to the index. So, if your equity mutual fund scheme has a high R-Squared value, it is performing similarly to an index fund. You may end up paying a higher expense ratio for the active management but get only returns similar to a passively managed index fund.
Standard deviation – It is used to measure the volatility of the annual rate of return of a mutual fund scheme or stock. The more volatile the fund scheme, the higher would be its standard deviation. Standard deviation is the deviation of data from its mean. In mutual funds, the mean is the expected return, as measured based on its historical performance.
Sharpe ratio – It divides the fund’s returns by their standard deviation after deducting the risk-free rate of return from it. It is used to find out if the fund returns were achieved through good decision-making or excessive risk-taking. A fund with a higher Sharpe ratio indicates better risk-adjusted returns.
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