# How to calculate Mutual Fund Risk

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```					How to calculate Mutual Fund Risk We know that shares carry a risk but are mutual funds also risky? Well any investment decision has to carry a certain amount of risk-doesn’t it? So, it means that mutual funds also carry a risk profile with them. So how do you assess your mutual fund’s risk profile? Some of the tools available to assess your scrip’s riskiness can also be used to assess a mutual fund's risk (or its close cousin, volatility). Beta This common measure compares a mutual fund's volatility with that of a benchmark and is supposed to give some sense of 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. A fund with a beta greater than 1 is considered more volatile than the market; less than 1 means less volatile. So say 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 should outperform by 15%. If the market heads lower, the fund should fall by 15% more. But beta, though a useful guide, is far from perfect, especially when used as a proxy for "risk." The problem here, as with many risk measures, is the benchmark. The benchmark has to be a correct measure of comparison only then will the beta hold any indicative value. Alpha Alpha was designed to take beta one step further. It looks at the relationship between a fund's historical beta and its current performance, or the difference between the return beta would lead you to expect and the return a fund actually gets. An alpha of 0 simply means that the fund did as well as expected, considering the risks it took. So if that fund with the beta of 1.15 beat the market by 15% (or underperformed it by 15% when the market was down), it would have a 0 alpha. If your fund has a positive alpha, that means it returned more than its beta predicted. A negative alpha means it returned less. The trouble with alpha is that it's only as good as its beta. If the benchmark isn't appropriate to a fund in deriving its beta, then alpha, too, will be imprecise. Standard Deviation Meet the most popular of the risk measures -- one with a distinct advantage over beta. While beta compares a fund's returns with a benchmark, standard deviation measures how far a fund's recent numbers stray from its long-term average. For example, if Fund X 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%. A large standard deviation supposedly shows a more risky fund than a smaller one. But here, again, what's problematic is your reference point. The number alone doesn't tell you much. You have to compare one standard deviation with the others among a fund's peers. But a more glaring problem is that the standard deviation system rewards consistency above all else. A fund is considered stable based on the uniformity of its own monthly returns. So if it loses money but does so very consistently it can have a very low standard deviation -- down 3% each and every month wins a standard deviation of zero. And likewise, a fund that gains 10% one month and 15% the next would be penalized by a high standard deviation -- a reminder that volatility, although perhaps a cousin to risk, itself isn't necessarily a bad thing. Sharpe Ratio This formula, worked by Nobel Laureate Bill Sharpe, tries to quantify how a fund performs relative to the risk it takes. 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 bigger the Sharpe ratio, the better a fund performed considering its riskiness. Here, again, you have the problem of relativity -- the ratio itself doesn't tell you anything, you have to compare it with the Sharpe of other funds. But this ratio has an advantage over alpha because it uses standard deviation instead of beta as the volatility variable, and therefore you don't have to worry that a fund doesn't relate

well to the chosen index. Overseas, one has mutual fund rating companies - like Morning Star which provide views of risk. Morningstar says that what we investors really care about is when our funds LOSE money, not when they're doing better than the benchmark or than their long-term averages. It measures how often and by how much a fund trails the monthly T-bill rate, and then compares that average loss with that for the investment class. The average for a class is 1.00, so numbers above that mean a fund is riskier than its peers, and below is considered less risky. In India we still have to introduce this kind of a risk rating. However till then remember one needs to be conscious of risk, but not push it to the last decimal point. It's about awareness, rather than mathematics.

5 pointers to Mutual Fund performance More often than not meritocracy of investments is often decided by the returns. Quite simply then a fund generating more returns than the other is considered better than the other. But this is just half the story. What most of us would appreciate is the level of risk that a fund has taken to generate this return? So what is really relevant is not just performance or returns. What matters therefore are Risk Adjusted Returns. The only caveat whilst using any risk-adjusted performance is the fact that their clairvoyance is decided by the past. Each of these measures uses past performance data and to that extent are not accurate indicators of the future. As an investor you just have to hope that the fund continues to be managed by the same set of principles in the future too.

Standard Deviation The most basic of all measures- Standard Deviation allows you to evaluate the volatility of the fund. Put differently it allows you to measure the consistency of the returns. Volatility is often a direct indicator of the risks taken by the fund. The standard deviation of a fund measures this risk by measuring the degree to which the fund fluctuates in relation to its mean return, the average return of a fund over a period of time. A security that is volatile is also considered higher risk because its performance may change quickly in either direction at any moment. A fund that has a consistent four-year return of 3%, for example, would have a mean, or average, of 3%. The standard deviation for this fund would then be zero because the fund's return in any given year does not differ from its four-year mean of 3%. On the other hand, a fund that in each of the last four years returned -5%, 17%, 2% and 30% will have a

mean return of 11%. The fund will also exhibit a high standard deviation because each year the return of the fund differs from the mean return. This fund is therefore more risky because it fluctuates widely between negative and positive returns within a short period.

Beta Beta is a fairly commonly used measure of risk. It basically indicates the level of volatility associated with the fund as compared to the benchmark. So quite naturally the success of Beta is heavily dependent on the correlation between a fund and its benchmark. Thus if the fund's portfolio doesn't have a relevant benchmark index then a beta would be grossly inadequate. A beta that is greater than one means that the fund is more volatile than the benchmark, while a beta of less than one means that the fund is less volatile than the index. A fund with a beta very close to 1 means the fund's performance closely matches the index or benchmark. If, for example, a fund has a beta of 1.03 in relation to the BSE Sensex, the fund has been moving 3% more than the index. Therefore, if the BSE Sensex increased 10%, the fund would be expected to increase 10.30%. Investors expecting the market to be bullish may choose funds exhibiting high betas, which increase investors' chances of beating the market. If an investor expects the market to be bearish in the near future, the funds that have betas less than 1 are a good choice because they would be expected to decline less in value than the index.

R-Squared The success of Beta is dependent on the correlation of a fund to its benchmark or its index. Thus whilst considering the beta of any security, you should also consider another statistic- R squared that measures the Correlation. The R-squared of a fund advises investors if the beta of a mutual fund is measured against an appropriate benchmark. Measuring the correlation of a fund's movements to that of an index, R-squared describes the level of association between the fund's volatility and market risk, or more specifically, the degree to which a fund's volatility is a result of the dayto-day fluctuations experienced by the overall market. R-squared values range between 0 and 1, where 0 represents no correlation and 1 represents full correlation. If a fund's beta has an Rsquared value that is close to 1, the beta of the fund should be trusted. On the other hand, an R-squared value that is less than 0.5 indicates that the

beta is not particularly useful because the fund is being compared against an inappropriate benchmark.

Alpha Alpha = (Fund return-Risk free return) - Funds beta *(Benchmark returnrisk free return). Alpha is the difference between the returns one would expect from a fund, given its beta, and the return it actually produces. An alpha of -1.0 means the fund produced a return 1% higher than its beta would predict. An alpha of 1.0 means the fund produced a return 1% lower. If a fund returns more than its beta then it has a positive alpha and if it returns less then it has a negative alpha. Once the beta of a fund is known, alpha compares the fund's performance to that of the benchmark's risk-adjusted returns. It allows you to ascertain if the fund's returns outperformed the market's, given the same amount of risk. The higher a funds risk level, the greater the returns it must generate in order to produce a high alpha. Normally one would like to see a positive alpha for all of the funds you own. But a high alpha does not mean a fund is doing a bad job nor is the vice versa true. Because alpha measures the out performance relative to beta. So the limitations that apply to beta would also apply to alpha. Alpha can be used to directly measure the value added or subtracted by a fund's manager. The accuracy of an alpha rating depends on two factors: 1) the assumption that market risk, as measured by beta, is the only risk measure necessary; 2) the strength of fund's correlation to a chosen benchmark such as the BSE Sensex or the NIFTY.

Sharpe Ratio Sharpe Ratio= Fund return in excess of risk free return/ Standard deviation of Fund So what does one do for funds that have low correlation with indices or benchmarks? Use the Sharpe ratio. Since it uses only the Standard Deviation, which measures the volatility of the returns there is no problem of benchmark correlation. The higher the Sharpe ratio, the better a funds returns relative to the amount of risk taken. Sharpe ratios are ideal for comparing funds that have a mixed asset classes. That is balanced funds that have a component of fixed income offerings.

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 views: 2725 posted: 12/16/2008 language: English pages: 5
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