Risk Analysis of Mutual Funds

Published: 24 June 2013

mutual funds risk

 
Mutual funds operate on various themes which exposes them to
different kind of risks. Although they are professionally
managed but element of risk still remains. These risks can be
attributed to economic performance, diversification, sector
growth and individual company performance. Prior to taking an
investment decision investors should crosscheck funds
performance with respect to various risk measures.In this
article we will try to understand the parameters using which
funds performance is measured and risk analysis is done.
Investors must perform comparative analysis of these
parameters before making an investment decision.
 

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Risk measures of mutual fund
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 Standard Deviation as a measure of risk

Risk is basically not getting what was expected. Standard deviation is a measure of risk which depicts the probability
of deviation from the mean return.
 
Example
Data of two mutual funds are presented in the table below:
 
  Mutual Fund A Mutual Fund B
Mean Return 15% 18%
Standard Deviation 5% 10%
 
What inference can be drawn from above data? Investor in mutual fund A and B should expect a return in the range of
-1 to 1 standard deviation of the mean return 68% of the time. If we do the calculation separately for fund A, return
comes in the range of 10% (15%-5%) to 20% (15%+5%) and for fund B its 8% (18%-10%) to 28% (18%+10%). Do not
worry about the calculation and focus on the result only. Similarly investor should expect a return in the range of -2 to 2
standard deviations 95% of the time. Do the calculation yourself for this case so as to understand it thoroughly (For
fund A the range should be 5% to 25% and for fund B range should be -2% to 38%).
 
While taking investment decisions lower value of standard deviation is preferred.
 
Beta as a Measure of Risk
Standard deviation discussed above is a measure of total risk whereas Beta is the measures of market risk which
cannot be diversified away. Market risk is attributed to overall economic scenario and it does not take individual
companies performance into account.
 
Example
Data of two mutual funds are presented in the table below:
 
  Mutual Fund A Mutual Fund B
Beta 1.2 0.7
 
Beta of 1.2 for mutual fund A means if the market or more logically the index which fund A tracks appreciates by 1%,
value of fund A should appreciate by 1.2%. Similarly, if the index depreciates by 1%, fund value will depreciate by 1.2%.
Do the calculation for mutual fund B and you will reach a value of 0.7% on either side.
 
While taking investment decisions lower value of Beta is preferred.
 
Sharpe Ratio
Merely looking at standard deviation of fund returns doesn’t help much while taking investment decisions. A more
meaningful ratio known as sharp ratio is available which inherently uses standard deviation data. Sharp ratio is defined
as (Fund return – Risk Free Rate)/Standard Deviation. It’s basically the funds excess return above risk free rate i.e.
guaranteed rate (Fixed Deposit rate for example) per unit standard deviation. Hence higher sharp ration is preferable
as compared to lower sharp ratio.
 
Example
Data of two mutual funds are presented in the table below:
 
  Mutual Fund A Mutual Fund B
Fund Return 15% 18%
Standard Deviation 5% 10%
Risk Free Rate 8% 8%
 
Based on above data
 
The sharp ratio for Mutual Fund A = (15 – 8) / 5 = 1.4
The sharp ratio for Mutual Fund B (18 – 8) / 10 = 1
 
As per sharp ratio preference fund A is better even though fund B returns are higher. It’s recommended to compare the
sharp ratio before taking an investment decision.
 
Treynor Ratio
Treynor ratio definition is similar to Sharpe ratio with only difference regarding the risk measure in the denominator. We
use Beat (Market Risk) instead of standard deviation (Total Risk) here. So Treynor ratio is basically the funds excess
return above risk free rate i.e. guaranteed rate (Fixed Deposit rate for example) per unit market risk (Beta). Preference
rule is same as sharp ratio i.e. higher the Treynor ratio value, better it is.
 
Example
Data of two mutual funds are presented in the table below:
 
  Mutual Fund K Mutual Fund L
Fund Return 15% 18%
Beta 1.2 0.7
Risk Free Rate 8% 8%
 
Based on above data
 
The Treynor ratio for Mutual Fund K = (15 – 8) / 1.2 = 5.83
The Treynor ratio for Mutual Fund L (18 – 8) / 0.7 = 14.28
 
As per Treynor ratio preference rule, fund L is better than Fund K. It’s recommended to compare the Treynor ratio
before taking an investment decision.