Mutual Fund Performance Ratios: Alpha, Beta, SD, Sharpe Ratio

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With a variety of mutual funds, it often gets difficult to choose the right scheme. Numerous funds and fund managers generate significant returns over the long term and short term. But selecting the right investment for your goal is the key. Therefore, analyzing the performance of the mutual fund is very important.

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Merely tracking the historical returns and fund ranking will not help you choose the right fund. You should understand the manager’s ability to generate benchmark beating returns, asset allocation, risk management, and skill to manage the investment portfolio. Furthermore, measure the risk-adjusted returns and performance against the benchmark. This article covers why and how you should analyze mutual fund performance and the key mutual fund performance ratios.

Ways to Measure Mutual Funds Performance

There are multiple metrics that help you analyze mutual funds. Following are some of the most commonly used mutual fund performance ratios:

1. Alpha

Alpha is a risk-adjusted return metric. It is a measure that compares a fund’s performance to its benchmark. A fund with alpha zero means it has delivered the same returns as the benchmark. A negative alpha indicates that the fund has underperformed its benchmark. On the other hand, alpha greater than one indicated the fund’s outperformance.

Alpha = (Mutual Fund Return – Risk Free Return (R_f)) – [(Benchmark Return – Risk Free Return (R_f)) * Beta]

Alpha determines how much return you can expect from your mutual fund investment. When you look at the Alpha value of a mutual fund, you can estimate how much return the fund can potentially generate. Although a higher Alpha number can signal higher returns, it isn’t the only indicator to use when evaluating a fund’s performance.

2. Beta

Beta measures the sensitivity of a mutual fund towards the dynamic market movements. It’s a metric that measures how volatile a mutual fund portfolio is in comparison to the overall market. Looking at a mutual fund’s beta, you can get a sense of how the fund responds to market fluctuations. The beta of a market or benchmark is always one. A beta of less than one suggests lesser volatility when compared to the benchmark index. A beta greater than one suggests a high level of volatility.

Beta = (Mutual Fund Return – Risk Free Rate (R_f)) / (Benchmark Return – Risk Free Rate (R_f))

You can decide whether or not to include a mutual fund in your investment portfolio based on its beta value. Risk-averse investors should ideally choose funds with a beta less than 1, while risk-takers can pick funds with a high beta (greater than 1). Though beta can help you understand how risky a mutual fund is. It doesn’t give you any information about the fund’s inherent or absolute risk.

Learn: What is alpha and Beta in Mutual Fund

3. Standard Deviation

A standard deviation is a statistical measure of how much a portfolio’s returns deviate from its average. A mutual fund’s standard deviation reveals its volatility. It shows how far a mutual fund’s performance deviates from expected returns. A high standard deviation indicates a wider range of returns, whereas a lower value indicates a narrower range of returns.

Standard deviation measures the total risk of the mutual fund rather than just the market-related volatility. As a result, it is a more comprehensive statistic than beta.

To use standard deviation as a performance ratio, you need to compare two funds belonging to the same category. In other words, you cannot determine if the standard deviation of a fund is high or low without comparing it to other funds in the same category.

4. Sharpe Ratio

Sharpe ratio is a performance metric that helps in estimating a mutual fund’s risk-adjusted returns. Risk-adjusted returns are the returns a mutual fund generates over and above the risk-free rate of return. The higher the ratio, the better the investment return in comparison to the risk. A higher Sharpe ratio indicates better risk-adjusted returns. A negative Sharpe ratio, on the other hand, indicates that risk-free investments are preferable to a fund with a negative Sharpe ratio.

The Sharpe ratio takes into account an investment’s inherent risk (standard deviation). As a result, the Sharpe ratio aids in determining a fund’s return generating capacity for each unit of risk it absorbs.

Share Ratio = (Mutual Fund Returns – Risk Free Rate) / Standard Deviation

Sharpe ratio is a quantitative metric that gives you a snapshot of the fund’s performance. It aids in the comparison of two funds. You can also analyze the fund’s risk to understand if it is able to generate returns than the risk-free rate.

5. Information Ratio

Information ratio compares the risk-adjusted returns of a mutual fund portfolio to its benchmark. The purpose of this ratio is to show excess returns relative to the benchmark, as well as the consistency with which excess returns are generated.

The information ratio is used to evaluate an asset manager’s trustworthiness, risk management expertise, and ability to outperform the benchmark. Using the information ratio, you can determine how successful a fund’s investment and allocation strategy is.

Information Ratio = (Portfolio Returns – Benchmark Returns)/ Tracking Error

The tracking error indicates how consistently the fund is able to generate excess returns over the benchmark. A low tracking error shows that the portfolio outperforms the benchmark on a consistent basis. The fund’s performance is highly volatile if the tracking error is high.

Why Should You Analyze the Performance of Mutual Funds?

Equity Mutual funds are not fixed income generating instruments. They are market-linked securities and therefore are subject to risks. We are well aware of the disclaimer ‘Mutual Fund investments are subject to market risks.’ This means that equity mutual fund investments are volatile, and their performance largely depends on the market conditions.
Furthermore, past performance doesn’t guarantee future returns. In other words, you cannot merely depend on the past performance of a mutual fund and expect similar returns in the future. Therefore, you must consider parameters beyond historical returns when evaluating a mutual fund. Consider parameters such as fund manager, asset allocation, investment style, performance against the benchmark, and more. This helps you get a holistic view of the fund.
Also, your job isn’t done once you invest in a mutual fund. You need to analyze your investments regularly. Since the markets are volatile, the fund’s performance can change with the changing market dynamics. Moreover, to keep your asset allocation intact and your goals on track, you need to monitor and analyze your investments.
For instance, with the changing market dynamics, a fund may not generate the desired returns to achieve your investment target. Or the asset allocation set by you for your investment portfolio is no longer the same. Such scenarios will require you to revisit your investments. Furthermore, analyzing a mutual fund will also help you find other similar funds that perform better.
Change in fund manager, change in the investment objective of a fund or continuous underperformance of the fund against the benchmark may require you to track the mutual fund’s performance closely. The change may not fit well with your investment goal or may not generate significant returns. Hence, you need to review and rebalance the investments as may be necessary.

How Often Should You Analyze Mutual Fund Performance?

You should not analyze your investment every day or every time the market crashes. Markets are cyclical in nature. Only when you invest for long durations, you can enjoy significant returns. Therefore, you should review and analyze your mutual fund performance every six months to one year. An annual review will help you gauge the performance of the fund better. Short term reviews may not provide accurate insights.

Also, actively managed schemes require time and patience. Equity schemes are highly volatile in the short term, and only in the long term, you’ll be able to enjoy significant growth. Since thematic or sectoral funds are more susceptible to market conditions, you may have to review them quite often than the other type of funds.

Always keep a close eye on funds that are underperforming the benchmark. Observe the performance of such funds for two to three quarters before you choose to exit. A prolonged underperformance is a signal for you to exit the investment. You need to also understand the reason for such underperformance.

The fund manager buys and sells stocks regularly. This changes the portfolio composition and the associated risks. The risk parameters are key for analyzing a fund’s performance. It may be prudent to exit the fund if the fund’s risk profile has shifted further towards ‘High’ risk while the returns have remained the same or have decreased.

As a result, you need to consider the fund’s risk-adjusted return, i.e., a metric for determining how much return investment can generate at a given level of risk. We all wish for high returns with minimal risk.

Also, funds that perform well today don’t necessarily generate significant returns in the future. Therefore, you should always analyze your portfolio from time to time.