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Understanding risk measures for smart investment decisions

Most investors are clueless as to how to gauge a fund while investing in it. And as the usual way goes, most often invest looking at the appreciation in the Net Asset Value (NAV) of the fund. However, while returns are a good indicator of the performance, they are not the only factor to take into consideration. There is something more beyond returns and most of us would have read about these in a mutual fund factsheet without realizing what they mean and how to understand them.
Let’s understand what these are. These are statistical tools or risk measures which gives an idea as to how the fund could move relative to the market and the risk component involved in the fund. Why should one look at these and what do these numbers have to tell us?


Alpha
This measure enables us to ascertain the performance of the fund manager. The calculation of the ratio is rather complicated and in essence the ratio measures the excess returns produced by the fund over and above the risk free rate of return. Hence a positive figure shows that the fund has rewarded you with a relatively higher return for the risk assumed by you. A negative return would indicate that you have had to contend with lower than the risk free return despite assuming higher risk.


Beta
The Beta is a measure of the fund’s sensitivity to market movements and a Beta is 1 by definition. Usually the index used for calculating beta is the benchmark of the fund. Based on past trends, high beta has been associated with high volatility and low beta has come to reflect less volatile stocks. This is because a low beta fund would ideally rise less than the index during a bull phase, but then it would also fall less than the index during a bear phase. This tool is apt for conservative investors whose primary focus is to preserve capital. They should look for schemes with low beta while aggressive investors can opt for funds which have a higher beta.


Standard Deviation
Standard Deviation shows how much the return of a particular fund is deviating from the expected returns based on its historical performance. In other words, it can be said that it evaluates the volatility of the fund. The higher the number, the more volatile is the fund’s return.
As the standard deviation increases, so does the return due to the risk-return trade-off. If two funds with same investment objectives deliver similar returns, the one with the lower standard deviation could be a better choice as it maximises the returns for the given risk level.
Equity funds will have a higher standard deviation than balanced funds, and debt oriented funds will have a still lower standard deviation. One must realise that like most statistics, Standard Deviation is truly meaningful as a comparative measure. On a standalone basis the measure is of little use.


Sharpe ratio
This is one ratio that sums up the risk- return profile of a portfolio most concisely. The ratio is calculated by subtracting the risk – free return from the return generated by the portfolio. This is then divided by the volatility or risk of the portfolio, as measured by the standard deviation of the portfolio. The risk-free return here is considered to be the 181-day treasury bill rate or the 10-year government bond.
The net result measures the return generated per unit of risk assumed by the portfolio in question. Hence one can easily measure how effectively a fund is using the risk assumed by it. Funds with a higher Sharpe ratio are therefore considered better than those with a lower Sharpe on a risk adjusted basis.


R Squared
R-squared measures the co-relation between the returns generated by the fund and its benchmark index. This tool is used in conjunction with the Beta. It shows how reliable the beta number is. The number is usually between zero to one. R-squared measuring 1 indicates perfect co-relation and implies that the fund’s portfolio is a mirror image of its benchmark. This is usually the case in index funds. For diversified equity funds, an R-squared greater than 0.8 suggests that the underlying beta value is reliable and can be used to assess returns movement of a fund vis-à-vis its stated benchmark.
These measures are available in a fund’s factsheet and need not be calculated by an investor. Armed with this knowledge of how to assess risk-adjusted returns of mutual funds, we hope you will make wiser investment decisions.


Source: Internal, Factsheet, Business Standard, Economic Times


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Disclaimer – This information is for general information only and does not have regard to particular needs of any specific person who may receive this information. L&T Investment Management Limited, the asset management company of L&T Mutual Fund or any of its associates; does not guarantee/indicate any returns/and shall not be held liable for any loss, expenses, charges incurred by the recipient. The recipient should consult their legal, tax and financial advisors before investing. Recipient of this information should understand that statements made herein regarding future prospects may not be realized or achieved.

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