How to calculate Mutual Fund Risk?

In the present market condition where markets are swinging to and fro like pendulum, selecting the right mutual funds for one’s portfolio has become quite a challenging exercise. For any investment first step to unbeaten investing is to figure out your financial goals and risk tolerance because every type of investment, including mutual funds, involves risk. We can calculate MF risk with the same tools available to assess stocks. Some of the tools are explained below.

Beta

Beta compares a mutual fund’s volatility with that of a benchmark and is supposed to give some sense how far you can expect a fund to fall when the market takes a dive, or how high it might climb if the bull is running hard. It is calculated using regression analysis beta as the tendency of a security’s returns to respond to swings in the market.

A fund with a beta greater than 1 is considered more volatile than the market whereas less than 1 means less volatile then the market.

Imagine that your fund gets a beta of 1.15 — it has a history of fluctuating 15% more than the benchmark if the market is up, the fund will outperform by 15%. If the market heads lower or dips, the fund will fall by 15% more.

Alpha

Alpha is an advance instrument designed to take beta one-step further. It takes the volatility (price risk) of a mutual fund and compares its risk-adjusted performance to a benchmark index. The excess return of the fund relative to the return of the benchmark index is a fund’s alpha.

A positive alpha of 1.0 means the fund has outperformed its benchmark index by 1%. Correspondingly, a similar negative alpha would indicate an underperformance of 1%.

Sharpe Ratio

It tries to quantify how a fund performs relative to the risk it takes.  For Example take a fund’s returns in excess of a guaranteed investment (a 90-day T-bill) and divide by the standard deviation of those returns. The greater the Sharpe ratio, the better a fund performed considering its riskiness.

R-Squared (R2)

It reveals what percentage of a fund’s movements can be related to movements in its benchmark index. An R-Squared of 100 would mean that all of the fund’s movements are perfectly explained by its benchmark. 

Standard Deviation

Standard deviation shed light on historical volatility. It is applied to the annual rate of return of an investment to measure the investment’s volatility.  It measures how far a fund’s recent numbers stray from its long-term average.  For example, if Fund A has a 10% average rate of return and a standard deviation of 5%, most of the time, its return will range from 5% to 15%.

Concluding, I would like to say that using the above mentioned tools one can provide some balance to the risk-return equation. If we use honestly the tools then we will better understand our investments, and perhaps will give us a truly full picture of our portfolio.           

Source: Investopedia.com