8/8/2019 How to calculate Mutual Fund Risk

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How to calculate Mutual Fund Risk

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We know that shares carry a risk but are mutual funds also risky? Well any investmentdecision has to carry a certain amount of risk-doesn’t it? So, it means that mutual fundsalso carry a risk profile with them. So how do you assess your mutual fund’s risk profile?Some of the tools available to assess your scrip’s riskiness can also be used to assess amutual fund's risk (or its close cousin, volatility).

BetaThis common measure compares a mutual fund's volatility with that of a benchmark andis supposed to give some sense of how far you can expect a fund to fall when the markettakes a dive, or how high it might climb if the bull is running hard. A fund with a beta

greater than 1 is considered more volatile than the market; less than 1 means less volatile.So say your fund gets a beta of 1.15 -- it has a history of fluctuating 15% more than the benchmark If the market is up, the fund should outperform by 15%. If the market headslower, the fund should fall by 15% more.

But beta, though a useful guide, is far from perfect, especially when used as a proxy for "risk." The problem here, as with many risk measures, is the benchmark. The benchmark has to be a correct measure of comparison only then will the beta hold any indicativevalue.

Alpha

Alpha was designed to take beta one step further. It looks at the relationship between afund's historical beta and its current performance, or the difference between the return beta would lead you to expect and the return a fund actually gets. An alpha of 0 simplymeans that the fund did as well as expected, considering the risks it took. So if that fundwith the beta of 1.15 beat the market by 15% (or underperformed it by 15% when themarket was down), it would have a 0 alpha. If your fund has a positive alpha, that meansit returned more than its beta predicted. A negative alpha means it returned less. Thetrouble with alpha is that it's only as good as its beta. If the benchmark isn't appropriate toa fund in deriving its beta, then alpha, too, will be imprecise.

Standard DeviationMeet the most popular of the risk measures -- one with a distinct advantage over beta.While beta compares a fund's returns with a benchmark, standard deviation measureshow far a fund's recent numbers stray from its long-term average. For example, if Fund Xhas a 10% average rate of return and a standard deviation of 5%, most of the time, itsreturn will range from 5% to 15%. A large standard deviation supposedly shows a morerisky fund than a smaller one. But here, again, what's problematic is your reference point.The number alone doesn't tell you much. You have to compare one standard deviationwith the others among a fund's peers. But a more glaring problem is that the standard

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deviation system rewards consistency above all else. A fund is considered stable based onthe uniformity of its own monthly returns. So if it loses money but does so veryconsistently it can have a very low standard deviation -- down 3% each and every monthwins a standard deviation of zero. And likewise, a fund that gains 10% one month and15% the next would be penalized by a high standard deviation -- a reminder that

volatility, although perhaps a cousin to risk, itself isn't necessarily a bad thing.

Sharpe RatioThis formula, worked by Nobel Laureate Bill Sharpe, tries to quantify how a fund

performs relative to the risk it takes. Take a fund's returns in excess of a guaranteedinvestment (a 90-day T-bill) and divide by the standard deviation of those returns. The

bigger the Sharpe ratio, the better a fund performed considering its riskiness. Here, again,you have the problem of relativity -- the ratio itself doesn't tell you anything, you have tocompare it with the Sharpe of other funds. But this ratio has an advantage over alpha

because it uses standard deviation instead of beta as the volatility variable, and thereforeyou don't have to worry that a fund doesn't relate well to the chosen index.

Overseas, one has mutual fund rating companies - like Morning Star which provide viewsof risk. Morningstar says that what we investors really care about is when our fundsLOSE money, not when they're doing better than the benchmark or than their long-termaverages. It measures how often and by how much a fund trails the monthly T-bill rate,and then compares that average loss with that for the investment class. The average for aclass is 1.00, so numbers above that mean a fund is riskier than its peers, and below isconsidered less risky.

In India we still have to introduce this kind of a risk rating. However till then remember one needs to be conscious of risk, but not push it to the last decimal point. It's aboutawareness, rather than mathematics.

Aru Srivastava

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