5 Important Mutual Fund Ratios You Must Know

Are you planning to invest in mutual funds? Choosing a mutual fund requires a certain level of research and basic understanding of how the investment works. Before investing in a mutual fund, you can evaluate the following five important ratios to make informed investment decisions.

Standard Deviation

Standard deviation represents how much a mutual fund’s returns move away from its average return. A higher standard deviation means the fund’s returns experience higher fluctuations, while a lower standard deviation means returns have been more stable.

For example, if a fund’s average return is 15% and its standard deviation is 4%, its past returns were generally around the average.

Standard deviation measures total volatility, unlike beta, which measures how and in which direction a fund moves compared with its benchmark. Investors are recommended to compare standard deviation among similar funds, such as two small-cap funds.

However, standard deviation only looks at past data and treats big gains and big losses as volatility.

Alpha

Alpha measures how much extra return a mutual fund generated compared to the expected return based on its risk and benchmark index. A positive alpha generally means the fund performed better than expected, while a negative alpha means the returns were lower than expected.

Formula: Alpha(∝)=Rp-[Rf+β x (Rm-Rf)]

Where,

• Rp: Actual return of the mutual fund. • Rf: Risk-free rate of return from a low-risk investment, such as a Treasury bill. • β (Beta): Measure of the fund's systematic risk relative to the market. • Rm: Return of the market benchmark index.

For example, if a mutual fund has a positive alpha, it means the fund generated more return than expected after considering its market risk. However, alpha is based on past data and does not guarantee that the fund will continue to generate extra returns in the future.

An alpha of zero means the fund delivered the return expected for the level of risk it took.

Treynor Ratio

Developed by American economist Jack Treynor, the Treynor Ratio measures how much extra return a mutual fund generated for each unit of beta.

Unlike standard deviation, which looks at total volatility, the Treynor Ratio uses beta, which measures how sensitive a fund is to changes in its benchmark. A beta of 1 means the fund has historically moved roughly in line with its benchmark, while a beta of 1.3 means it has been about 30% more sensitive to movements in the benchmark.

For example, a fund may give a 20% return, but if it took much more market risk to achieve that return, another fund may have a better Treynor Ratio.

Formula: (Fund Return − Risk-Free Rate) ÷ Beta.

A higher Treynor Ratio generally indicates better risk-adjusted performance.

Sharpe Ratio

The Sharpe Ratio measures how much excess return a mutual fund generates above the risk-free rate for each unit of volatility, based on standard deviation.

Formula: (Fund Return − Risk-Free Rate) ÷ Standard Deviation.

A higher Sharpe Ratio generally means better risk-adjusted performance.

For example, if two funds give similar returns, the fund with the higher Sharpe Ratio has generally delivered those returns with less volatility.

However, there are no fixed rules saying that a Sharpe Ratio below 1 is bad or that a ratio above 3 is excellent. These numbers should be compared with similar funds and over the same period. The Sharpe Ratio is based on past data, so it does not guarantee future performance and treats both gains and losses as volatility.

Expense Ratio

The Total Expense Ratio (TER) is the annual cost of running a mutual fund, shown as a percentage of the fund’s assets. It covers expenses such as fund managers' fees, administration, and other operating costs.

You do not pay the expense ratio separately, as these expenses are reflected in the fund’s NAV. So the returns shown by the fund are after deducting the expenses. SEBI prescribes limits on the expenses that mutual fund schemes can charge. These limits vary by scheme type and assets under management (AUM). The applicable expense ratio limits and permitted additional expenses are subject to SEBI regulations and amendments.

Direct plans usually have lower expense ratios because they do not include distributor commissions, while regular plans generally have higher expenses due to distributor fees.

FAQs

What is standard deviation in a mutual fund?

Standard deviation measures how much a fund’s returns have moved away from its average return in the past.

What does a positive alpha mean?

A positive alpha means the fund performed better than expected based on its risk and benchmark.

Is a higher Sharpe Ratio better?

Yes, a higher Sharpe ratio generally means the fund gave better returns for the risk it took.

Why must investors assess the expense ratio of a mutual fund?

The expense ratio is the fee charged to cover the costs of running a mutual fund. A lower expense ratio can help investors keep more of their returns, while a higher expense ratio would reduce their overall return.