The investment of capital into market comes up with its associated risk factors. These risk factors are indicative of the rate of returns that these mutual funds will provide. Mutual funds with higher risk factors provide high returns on capital and those with low risk profile keep investment safe with small returns. Mutual funds are chosen based up on various factors and the risk factor plays a major role in it.
Investments in the mutual funds require regular validation so as to ensure that invested money is not at loss. Similarly, it is necessary to evaluate risks associated with mutual funds in your financial portfolio. Mutual funds chosen solely based upon the past performance can put investment at loss. With proper risk evaluation methods, one can prevent the loss and gain desired returns from market. Risk factors should be validated regularly on yearly basis.
A balance should be maintained between the volatility risk factor and good returns associated with a mutual fund in your portfolio. There are several methods by which one can measure mutual fund risk.
These are methods that would help in measuring the mutual fund risk –
- Standard deviation. It is one of the best methods to measure risk associated with mutual fund. It is an indicative of mutual fund volatility or deviation of actual returns from that of the expected returns in past years over a fixed time period. A fund having an average rate of return of 15% with a standard deviation of 5% shows that returns can disperse in the range 10% to 20%.
For instance, Fund A has an average return of 19% with standard deviation of 10% and Fund B has an average return of 19% with standard deviation of 15%. Out of these two, Fund A is safer than Fund B because the deviancy of Fund A is less and thus it is less risky or volatile than Fund B.
This method is used only to compare risk factor amongst peer group of mutual funds.
Lower the S.D., better is the mutual fund.
- Sharpe Ratio. Discovered by Nobel Laureate economist William Sharpe, it is one of the most efficient mutual fund risks measuring method. It involves risk adjusted measurement of returns which in turn helps to compare the mutual fund performance of two different funds. It is known to evaluate the returns generated by mutual funds in respect of risk taken by it. Higher is Sharpe Ratio better is the mutual funds.
For example, fund manager A is generating returns of 18% and fund manager B is generating that of 15% returns. According this data, former fund is better. The risk free return is of 5%. If the former manager takes higher risk with standard deviation of 8% and latter one takes lesser risk with standard deviation of 5%. The best fund would be latter one as Sharpe Ratio of A would be lesser than B.
It allows the comparison between the peer group funds.
- Beta. It is used to measure sensitivity of mutual fund in accordance to the market changes. The benchmark of beta is fixed, i.e., 1. A mutual fund with a beta value less than 1 is underperforming and is less volatile whereas the fund with beta value higher than 1 is highly performing and is highly volatile. Beta value is used to calculate alpha of mutual funds.
For the beta value to be significant in measuring risk factor, correlation of mutual and market fund should not be less than 0.7 (i.e. 70%).
- Alpha. This method is used to measure mutual fund risk factor every year. It is a comparison of yearly returns of the mutual funds with respect to benchmark index. A positive alpha with the value of 10% indicates that fund have performed well with respect to its benchmark by 10%. And a negative alpha of 10% indicated the underperformance of mutual funds from its benchmark.
The higher value of alpha, the better is that particular mutual fund.
- R-Squared Method. This method is used to analyze correlation between beta values of mutual funds to its benchmark. The significance of beta is calculated by this method.
The R-squared value varies from 0 to 1. Fund having R-squared value above 0.85 have high correlation and thus higher beta, whereas funds below 0.70 are less reliable.
Lesser the R-squared value, lesser is the correlation and thus less reliable is the beta.
However, these methods cannot calculate risk factors in isolation. They are comparative methods and are used widely to measure the risk with respect to other mutual funds.