Investors usually start investing in mutual funds looking at their past performance. However, it is of paramount importance that investors consider the risk that mutual fund will expose them to, after all risk and return are two sides of the same coin. Remember that in mutual fund investments, higher returns is generally associated with higher risk.

The risks related to mutual fund investment can be quantified using various ratios. Evaluating these ratios helps you to gauge the risk-adjusted returns of a scheme. This will hep you to make informed investment decision as you will be able to assess the suitability of the scheme to your risk profile.

Do note that risk-adjusted returns should be used to compare schemes within the same category and with comparable indices (and not apples with oranges).

In this article, we will acquaint you with three important ratios to help you evaluate the risk-reward trade-off of mutual funds.

#1: Sharpe Ratio

Sharpe Ratio is a commonly used measure to compare risk-adjusted returns of two or more funds within a category. This ratio shows how much return an investor is earning in correlation to the level of risk being undertaken.

It’s calculated by taking the difference between the returns of the investment and the risk-free return, divided by the standard deviation of the asset.

Sharpe Ratio = (Fund Return – Risk-free Return)/Standard Deviation of the Fund

By looking at the Sharpe Ratio you can assess the degree of risk (indicated by standard deviation) that a fund took to generate extra returns over risk-free instruments, such as 10-year G-Sec bonds.

The higher the Sharpe Ratio, the better is the fund’s ability to reward investors with higher risk-adjusted returns.

If a fund’s standard deviation is higher, it needs to earn a higher Sharpe Ratio to justify the excess risk taken. The Sharpe Ratio can also be used to compare the outperformance/underperformance of a mutual fund relative to its benchmark index.

(For illustrative purpose only)  

The above table shows that though Fund A has generated higher returns, it has done so by taking higher risk.

From a risk-reward perspective, as denoted by the Sharpe Ratio, both the funds are similar. This means, there is no additional advantage to choosing Fund A over Fund B.

Ideally, investors should pick a mutual fund scheme that does not chase high returns by exposing the portfolio to very high risk.

#2: Sortino Ratio

The Sortino ratio is a helpful measure to determine a fund’s ability to contain the downside risk, especially during depressed market conditions.

Unlike the Sharpe Ratio, Sortino uses only downside deviation for calculating the risk instead of the total volatility of the portfolio. The downside risk denotes returns that fall below a minimum threshold such as risk-free returns and/or negative returns.

For instance, a fund has generated returns of 20%, 9%, 3%, 8%, -3%, -2%, and 5% respectively, in the last seven years.

Assuming that the risk-freerate is 6%, the returns below this limit will be included. In this case 3%, -3%, -2%, and 5% returns will be considered as downside deviation.

Sortino Ratio = (Fund Return – Risk-free Return)/Downside Deviation

Just as with any investment, all mutual funds come with possible downside risk. However, some schemes have a better ability to manage the downside risk and thereby optimise the returns. Thus, the Sortino Ratio is an important ratio to measure risk-adjusted returns.

(For illustrative purpose only)  

The higher the Sortino Ratio, the better is the fund’s potential of earning higher returns by not taking unwarranted risk. From the above table, Fund Y’s Sortino Ratio indicates it’s generating more returns per unit for the level of risk taken. It has a greater chance of avoiding any potential losses.

The Sortino Ratio is particularly helpful when the markets are highly volatile as it will have many data points to calculate downside deviation.

# 3: Treynor Ratio

The Treynor Ratio is used for determining the excess returns earned per unit for a given level of systemic risk.

While the Sharpe Ratio uses standard deviation for calculating risk-adjusted returns, the Treynor Ratio uses the ‘Beta’ of the fund (a measure of systemic risk).

The idea is that mutual funds should compensate investors by efficiently managing the assets in the portfolio to generate a risk premium because systemic risk (market risk) cannot be mitigated by diversification.

Treynor Ratio = (Fund Return – Risk-free Return)/Beta of the Fund

The Beta of a mutual fund scheme is its volatility relative to its benchmark index. A beta of more than 1 denotes that the mutual fund scheme is more volatile than its benchmark. While high Beta stocks/funds do well in a rising market, they can also fall more during a slump.

As mutual funds aim to outperform the underlying market index, the Treynor Ratio can be a useful ratio for assessing the scheme’s performance.

(For illustrative purpose only)  

In the above table, both Fund P and Fund Q have generated similar returns.

However, Fund P’s higher return has come from investing in a portfolio of highly volatile stocks. A Fund with a higher Treynor Ratio is better

This is because it has generated higher returns for each level of risk. This ratio also helps you to compare different funds and shortlist the one most suitable for your risk profile.

To conclude…

Earning higher returns is an important objective of mutual fund investment. But as we have seen, when you evaluate mutual fund schemes you cannot look at returns in isolation.

During a rising market, most mutual funds tend to do well. However, the performance may not sustain during uncertain or volatile market conditions. Thus, you need to factor in the risk involved and gauge the risk-adjusted returns generated by evaluating it based on various risk-reward ratios.

Different types of mutual funds, including schemes within the same category, carry different risk-reward profiles. Therefore, it is important to shortlist schemes that match your risk appetite, investment objective, the financial goal/s you are addressing, along with the investment horizon to achieve those goals to avoid taking undue risk.

It is important to note that market conditions and the composition of the portfolio of any scheme can undergo changes in the future. Accordingly, the scheme portfolio might become more or less vulnerable to risk. This makes it important to keep a periodic check on how efficiently the fund manager is managing risk in the race to generate better returns.

This article first appeared on PersonalFN here

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