Hello readers, last week you had an overview of mutual fund risk ratios and basic calculations. Today you will be going through the advanced methods in risk calculation.
“Mutual Fund Sahi Hai “ you would have seen this advertisement nowadays quite often. But, who teaches how to select the right scheme for mutual fund investments?
There are several schemes available in the market even the bull market. Asset Management companies come up with a New Fund Offer.
Whether we should invest in NFO or existing scheme. Let us try to simplify the answer through our analysis.
Investors mostly look at past performance, or get an idea from the mutual fund distributors, if is it the correct way to identify the scheme. No! Then how to do it.
Advanced Mutual Fund Risk Ratios:
- Sharp Ratio
- Sortino Ratio
- Information Ratio
Sharp Ratio:
The sharp ratio is used to calculate the risk-adjusted return potential of a mutual fund. Generally, risk-adjusted return happens to be the returns earned over and above the returns generated by risk-free assets like government bonds or fixed deposits. Every mutual fund investor wants to take the additional risk to get a higher return.
Sharp Ratio = (Average fund return – Risk-free Rate) / Standard deviation of fund returns
The sharp ratio measures the excess return on every additional unit of risk taken. However, a higher sharp ratio indicates better return yielding capacity compared to the risk-free assets.
Significance of Sharp Ratio:
- Measure the risk-adjusted returns of the fund.
- Compare the same category fund performance.
- To check the returns against the benchmark return.
Sortino Ratio:
Fundamentally, the Sortino ratio is a statistical tool that measures the fund performance with the downside standard deviation.
It does not include the volatility of the fund. It will help retail investors who are very much concerned about the downside risk in the market to identify the best investment scheme.
Sortino Ratio = Average Fund return – risk-free rate / negative asset returns the standard deviation
Let’s take a hypothetical example for your understanding
Suppose there are two investment portfolio schemes, namely scheme – A and scheme- B with the Annualized returns.
| PARTICULARS | Scheme- A | Scheme- B |
| Annualized returns | 12% | 16% |
| downward deviation | 4% | 10% |
| Rate of FD risk-free rate | 6% | 6% |
Scheme- A Sortino Ratio = (12-6) / 4 => 1.5
Scheme- B Sortino Ratio = (16-6)/ 10 => 1
Generally, a higher Sortino ratio in a mutual fund is considered to be better. In our example scheme- A’s ratio indicates that it is generating more return per unit of the given risk and a higher chance of avoiding heavy losses in the downside market.
It’s used to evaluate the investment portfolio with high volatility but in the case of the Sharp ratio evaluate the returns in a low volatility market.
Information Ratio:
It’s also called the appraisal ratio. The Information ratio measures the performance of the portfolio in regards to the benchmark index. In which it compares with the volatility of returns.
The benchmark is usually a market index, like Nifty 50, or Nifty 100. It can also be an index representing any industry or market sector.
Information Ratio = (Portfolio Return – Benchmark Rate of Returns)/ Tracking Error
Tracking error is the standard deviation of the investment portfolio’s excess returns concerning benchmark return.
To measure the annualized information ratio, we must multiply the ratio by the square root of 252. That’s the total trading days in a year.
Annualized IR = {(Portfolio return – bench-mark return) / tracking error} * ؆ 252
Let us give a step by step calculation for our understanding
- Note down the daily returns of a portfolio for a specified period like a month or quarter or even a year.
- Calculate the average of those returns, which is a portfolio return.
- Calculate the index rate of return in the same way
- Compute the difference between benchmark return and portfolio return
- Next, calculate the standard deviation of the excess return of the portfolio.
- Divide the difference in returns by the standard deviation to get the annualized information ratio.
A higher information ratio indicates that the portfolio is doing well which means the fund is posting excess return consistently. Other hand low information ratio signals a volatile portfolio, signifying high return but less predictability.
Conclusion – Mutual Fund Risk Ratios
- We have a clear idea of a mutual fund scheme to choose from based on the risk ratios. Try to find out the consistency of the mutual fund scheme returns over a period.
- Investors look at all the parameters and check the fund manager’s history, and how he generates the returns compared to the benchmark index returns.
- Investing is not an easy task. Before investing in any mutual fund schemes, please check these fundamental risk ratios.