Not every investment multiplies your returns in a short period, some take off gradually. That's where we need to learn more about 'Mutual Fund Ratios'. What are 'Mutual Fund Ratios'? And why are they so important to analyse?
Hello and welcome to our new series - Learn with Upstox.
In this series, we discuss ratio analysis, industry analysis, balance sheet analysis and many topics like that. But today, we will discuss some Mutual Fund Ratios.
We know that just because our friend could climb Mount Everest, doesn’t automatically make us capable of climbing it. And just like that if our friend could invest in mutual funds and receive amazing returns, that won’t automatically help us do the same. For that we need to learn how to do it and this article would help you do the same.
In this article, we are going to talk about the five important mutual fund ratios which will help us in making informed decisions.
Standard Deviation
Standard Deviation measures the dispersion of a data set relative to its mean.
Let’s take a simple example. Assume that we have a portfolio which gave a return of 15% in year one, minus 5% in year two, and 25% in year three. There is portfolio B, which gave a return of 10% in year one, 8% in year two, and 11% in year three. Now, who do you think was more consistent? A or B? Obviously the answer is that B was more consistent or we can say that the deviation was comparatively less.
We can even compare Portfolio A and B with Virendra Sehwag and Rahul Dravid. Virendra Sehwag’s inningings were something like - 100 runs in the first match, 200 runs in the second match and zero runs in the third match. But for Rahul Dravid, match one, match two and match three will have more or less the same runs. And here we can say that the standard deviation on Rahul Dravid’s runs was amazing because the deviation was comparatively less.
As an investor, if you don't want to take a lot of risk, always choose mutual funds with lower standard deviations.
Now, let’s move on to the second one.
Alpha Formula
Alpha is the risk adjustive measure of how a security performs in comparison to the overall market average return. The loss or profit achieved relative to the benchmark represents the alpha.
Now, let’s see what Alpha means in simple words.
Alpha denotes the investment manager’s ability to beat the market. Let’s assume that the expected returns from the market are 10% but the actual return that the fund manager is able to generate is 12%. In this case, the alpha is nothing but 12 - 10 = 2.
(Alpha = Actual returns - Expected returns)
Now, if we assume that the alpha for a specific mutual fund is 1.5%, it means that the fund has outperformed the benchmark by 1.5%. On the contrary, if the alpha is -1.5%, it means that the mutual fund returns were lower than the benchmark by 1.5%.
So, what is better? A higher alpha or a lower alpha? Obviously a higher one. That is why we should choose a mutual fund with a higher alpha.
Treynor Ratio
This ratio was named after an American economist Jack Treynor. It tells us how successful an investment is in providing compensation to the investors for taking an investment risk. It uses portfolio’s beta, that is the sensitivity of the portfolio's returns to the movements in the market to judge the risk. Let’s look at the formula:
Treynor ratio = Portfolio return minus the Risk free return divided by Portfolio beta.
Now, let’s try to understand this part.
What is portfolio return?
It is nothing but the return that the portfolio generates for me. If I assume that I got a return of 11%, then this is the portfolio return.
What is a Risk Free Return?
It is the return that I can get if I invest in government securities. It is called a risk free return because there is a very little chance of losing money if I invest in a government security. So, if I get a 5% return after investing in a government security, then the risk free return is 5%.
What is a portfolio beta?
A beta is the sensitivity to something. It could be the sensitivity to the market or the sensitivity to the benchmark. So a portfolio beta is a sensitivity to the market.
Now that we’ve understood these terms individually, let’s take an example.
Fund A has given a return of 11%, a risk free return of 5% and the portfolio beta is 2. So, what will be the treynor ratio? 11 - 5 divided by 2 = 3.
Now, what does this 3 mean? It implies that the fund gave 3 units of return for every additional unit of market risk assumed. In simple words, it’s a correlation between the amount of risk you take and the amount of returns you get for that. Which simply means that for one unit of risk you got back three units of return. This was case 1.
Now, there is a case 2. Here, for one unit of risk, you got back five units of return. And when we compare, which do you think is the best case? Obviously, the second one because it gives more returns on the same amount of risk.
Therefore, Choose a mutual fund with a higher Treynor ratio.
Moving on the next one, it is the Sharpe ratio.
Sharpe Ratio
Many people feel that the treynor ratio and the Sharpe ratio are the same. Indeed, the numerator is the same. What is different is the denominator. While the Treynor ratio considers only the systematic risk, the Sharpe ratio considers both the systematic as well as the non-systematic risk.
So, what is the formula for sharpe ratio?
It is calculated as - Portfolio risk minus Risk free return divided by the Standard deviation.
Remember that the numerator is the same and let’s take an example:
Consider that there are two investment managers - A and B.
The investment manager A generated a return of 15% while the investment manager B generated a return of 12%. What do you think - who performed better? A or B?
Obviously A right? But wait! Let’s look at more data.
The risk free return is the same for both of them - 5%. And manager A’s portfolio has a standard deviation of 8% while manager B’s portfolio has the standard deviation of 5%. Now, if we calculate the Sharpe ratio of A, it will be 15 - 5 divided by 8 which is equal to 1.25. On the other hand, for manager B, the sharpe ratio will be 12 - 5 divided by 5 which is equal to 1.4. Based on this, which one do you think is better? Manager B right? Because she was able to generate a higher return on the risk adjusted basis.
Which means, that for the previous one as well as this one we are trying to see how much more returns can one generate with the same amount of risk. And again, it is better to choose a mutual fund with a higher sharpe ratio.
Now, let’s talk about the last ratio for the article.
Expense Ratio
Let’s try to understand this. You invest money in a mutual fund, but the mutual fund also has its own expenses to bear. Like the fund management fee, the agents commission, registrar fees, auditor fees, advertising expenses and so many more. To manage these expenses the fund house charges fees for their services which is called the Expense Ratio. And SEBI has already set the limits for the Expense ratio.
The maximum limit prescribed by SEBI for equity funds is 2.5% per annum. In case of debt funds, it is 2.25% per annum. And in the case of Index funds, it is 1.5% per annum. But in terms of equity funds, SEBI has additionally defined slabs for charging of the expense ratio.
Well, the rule is simple - More the AUM, lesser will be the expense ratio. This expense ratio is not paid separately, but is deducted from your daily NAV and therefore, it is charged irrespective of whether a fund has generated a positive return or a negative return.
And that’s all for this article. I hope that you’ve understood these ratios and agree with me as we say, “Look before you Leap.” or “Study before you Invest.”
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Thank you and have a good day!