Understanding mutual fund ratios: A comprehensive guide for investors

Mutual funds combine the capital of numerous investors to purchase stocks, bonds, and short-term debt. Investors own units of the mutual fund, which represent their share in the fund’s net assets, but they do not directly own individual securities held by the fund.

Let’s understand the basics of mutual funds, their ratios, and types.

Mutual Fund Basics You Should Know

The following are the basics of mutual funds.

Assets under management (AUM)

AUM is the total market value of the assets managed by a mutual fund, including its investments and cash, before deducting liabilities. A rise in AUM can happen because of new investments, higher market prices, or both. A higher AUM does not always mean that the fund has performed well.

Net Asset Value (NAV)

NAV is the value of one mutual fund unit. Investors buy or redeem units at the applicable NAV, based on the scheme's rules and the timing of their transaction.

NAV = (Total Assets - Total Liabilities) / Total Number of Outstanding Units.

Jensen’s Alpha

Jensen’s Alpha measures how much a mutual fund's actual return differs from the return expected based on its market risk, measured by beta. If the alpha is positive, it means the fund earned more than expected, while a negative alpha means it earned less than expected.

Sharpe Ratio

Sharpe ratio measures the extra return a mutual fund earns above the risk-free rate for each unit of risk, measured by the standard deviation of its returns.

Sharpe Ratio = (Fund Return − Risk-Free Return) / Standard Deviation of Fund Returns.

Treynor Ratio

Treynor ratio measures the extra return a mutual fund earns above the risk-free rate for each unit of market risk, measured by beta.

Treynor ratio = (Fund Return − Risk-Free Return) / Fund Beta.

Expense Ratio

Expense ratio is the annual cost of managing and operating a mutual fund, expressed as a percentage of its assets. The expense ratio varies by scheme and plan. These expenses are accounted for in the scheme's NAV.

Tracking Error

Tracking error measures the variability in the difference between a fund's returns and those of its benchmark over time. Index funds and other passive funds may have tracking errors due to expenses, cash holdings, and differences in portfolio composition.

How to Calculate Risk-Adjusted Returns

The formula for calculating the Treynor Ratio, a measure of risk-adjusted returns, is:

Treynor Ratio = (Fund Return − Risk-Free Return) / Beta.

Example: A mutual fund has an 11.2% return, a risk-free return of 4%, and a beta of 3:

Risk-adjusted return = (11.2 - 4)/3 = 2.4%.

This helps you assess the fund's excess return for each unit of market risk. It is most useful when comparing funds with similar investment objectives and suitable benchmarks.

Classification of Mutual Funds

Mutual funds can be divided into different types depending on various criteria.

Fund Schemes

Open-ended schemes allow investors to buy and redeem units on business days at the applicable NAV, subject to the scheme's terms. Close-ended schemes have a fixed maturity date, and their units are generally listed on stock exchanges to give investors an exit option before maturity.

Fund Management

In actively managed funds, fund managers select investments to meet the fund's objectives. In passively managed funds, managers aim to track a benchmark index.

Assets

Debt funds invest mainly in fixed-income instruments, such as government securities, corporate bonds, treasury bills, and other money market instruments, while equity funds invest their assets in the stock market and generally carry higher risk.

Liquid funds invest in debt and money market instruments with a maturity of up to 91 days. Hybrid funds invest their money in both equity and debt instruments in different ratios.

Investment Objective

Growth funds aim to invest in companies that have the potential to grow their earnings and business value over time. They may also invest in companies that pay low dividends, but this is not a requirement. Value funds invest in stocks that appear to be priced below their estimated value. These stocks may have low price-to-earnings ratios or high dividend yields.

FAQs

What is a mutual fund?

A mutual fund pools money from many investors and invests it in assets such as stocks, bonds, and other securities.

What is NAV in mutual funds?

In mutual funds, NAV is the value of one mutual fund unit, and it changes based on the value of the fund's investments and liabilities.

What is the Sharpe ratio?

The Sharpe ratio measures how much extra return a mutual fund earns for the risk taken.

What is an expense ratio in mutual funds?

In mutual funds, the expense ratio is the annual cost of managing and operating a mutual fund. A lower expense ratio can help investors save on costs.