Key Ratios to Examine Prior to Investing in Mutual Funds
Investing in mutual funds calls for a meticulous examination of various aspects, and mutual fund ratios are key parameters to determine the performance, risk profile, and return potential of a fund. The ratios provide a basis to compare various funds and make smart choices based on the investment objectives.
Below are some of the key mutual fund ratios to be considered by the investors before investment:
1. Alpha
The alpha ratio estimates how well a mutual fund has performed in comparison to a benchmark index. Alpha can be determined either as an absolute value or a percentage.
- If alpha is zero, then it suggests that the performance of the fund is equal to its benchmark.
- A positive alpha signifies that the fund has outperformed the benchmark.
- A negative alpha indicates that the fund has performed below the benchmark.
2. Beta
The beta ratio indicates to what extent the volatility of a mutual fund aligns with the general volatility of the market. It is always an integer and either positive or negative.
- When the beta is 1, the volatility of the fund is of the same size as the market.
- When beta is greater than 1, it indicates that the fund is more volatile than the market.
- When beta is less than 1, it indicates that the fund is less volatile than the market.
- When the beta is negative, the fund will move in the opposite direction of the market.
The formula for beta:
Beta = (Covariance between fund returns and market returns) / (Variance of market returns)
3. Standard Deviation (SD)
The standard deviation ratio (SD) measures the degree of variability of the returns of a fund over a time horizon.
- A high standard deviation implies greater volatility.
- A low standard deviation implies that the fund is less volatile.
4. Sharpe Ratio
The Sharpe ratio is used to calculate the risk-adjusted return of a mutual fund. It checks whether the returns earned by the fund are in proportion to the risks incurred. The greater the Sharpe ratio, the better, particularly for riskier funds.
Formula for Sharpe Ratio:
Sharpe Ratio = (Fund returns – Risk-free rate) / Standard deviation of the fund
5. Treynor Ratio
Treynor ratio or reward-to-volatility ratio calculates the return in excess over the risk that a fund achieves for every unit of risk (beta). The higher the Treynor ratio, the greater the risk-adjusted return.
Treynor Ratio Formula:
Treynor Ratio = (Fund returns – Risk-free rate) / Fund’s beta
6. Information Ratio
The information ratio helps to identify how often a fund manager can earn returns higher than the benchmark. The more negative the ratio, the more frequently the fund manager has beaten the market.
7. Sortino Ratio
The Sortino ratio is an adaptation of the Sharpe ratio, which only considers downside risk. It is the risk-adjusted return of a fund, considering only negative deviations. The higher the Sortino ratio, the better the returns with lower downside risk.
Conclusion
These important mutual fund ratios give huge insights into a fund’s return, risk, and performance. These ratios can be used by investors to compare various mutual funds and make an investment decision on the basis of their risk profile and investment period.
