If you are to thrive as a mutual fund investor, you must understand the fundamentals of the relationship between risk and return on investment. It is essential to clearly understand that the chances of earning a higher return on investment increase considerably when you assume higher risk. However, you need to have adequate knowledge of risk-adjusted returns to comprehend the situation better. The performance of a mutual fund scheme is better evaluated when you look at its risk-adjusted returns rather than just returns. In this article, we have discussed risk-adjusted returns and Alpha and Beta, the parameters that help us better understand risk-adjusted returns.
What Exactly are Risk-Adjusted Returns?
When you are analysing the track record and returns generated by mutual fund schemes, you should not just look at their returns alone but also the risk associated with the investment. It is why you must determine risk-adjusted returns.
Risk-adjusted returns are nothing but a concept to measure a fund’s return on investment by considering the risk assumed by the fund manager to generate that return. You can apply risk-adjusted returns to individual assets and portfolios of investments such as mutual funds.
How to Calculate Risk-Adjusted Returns?
There are various financial parameters available to measure the risk-adjusted returns, and Alpha and Beta are two of the most popular ones. Apart from these, you may also rely on R-squared, Sharpe Ratio, and Standard Deviation. Each of these parameters provides investors with detailed information related to risk-adjusted returns.
What is Alpha?
Alpha is an indication of the additional returns that are generated by mutual fund schemes as against their respective benchmarks. For instance, if the S&P BSE Sensex is the benchmark to measure the performance of a given mutual fund scheme, Alpha tells you how much more returns the fund has produced over its benchmark.
If a given mutual fund’s Alpha is 4, it indicates that the fund has beaten its benchmark by 4%. It can be attributed to the value that the fund manager brings to the fore while managing their fund. Depending on the fund’s performance, Alpha can be positive or negative.
Furthermore, if the benchmark of a mutual fund is NSE Nifty 50, and the index has generated a return of 30% in the past year. And, if the fund’s Alpha is 3%, it means that the fund has managed to beat the index by 3% or has produced a return of 33% in the same duration. Likewise, a negative Alpha of 4% means the fund has underperformed against its index and has generated a return of 26%.
By knowing the value of Alpha, you will understand the fund’s performance in comparison to its benchmark. In this way, you will realise how better the fund has been against its benchmark for every additional unit of risk assumed by the mutual fund manager.
What is Beta?
Beta measures how sensitive a given mutual fund scheme is towards the stock market fluctuations. It can also be considered a measure of the volatility of a mutual fund scheme. Beta indicates the tendency of the movement of the fund’s performance when the markets move up and down.
The movement is gauged by considering a benchmark such as NSE Nifty 50 or S&P BSE Sensex. The Beta of the benchmark that is being tracked by a mutual fund scheme is always considered to be 1. A Beta of lower than 1 implies lower volatility, while a Beta of over 1 indicates that the fund is more volatile than the stock market.
For instance, if a given mutual fund has a Beta of 0.85, it is less volatile as compared to the stock market. It also implies that for every increase or decrease of 1 in the benchmark, the fund’s performance will increase or reduce by 0.85. Considering Beta of mutual funds is extremely important if you are a risk-averse investor as Beta tells you how sensitive a given mutual fund scheme is.
How Does Alpha Differ From Beta?
Even though both Alpha and Beta measure the past performance of mutual funds and indicate risk-adjusted returns, they do so in their own way. At the same time, Alpha measures the performance of a mutual fund against its benchmark, Beta measures the fund’s volatility in comparison to its benchmark.
A high Alpha is always desirable as it indicates benchmark-beating performance. On the other hand, a high Beta is not always desired, as it could mean the fund experiences higher losses during adverse stock market movements. Risk-averse investors may consider looking at mutual fund schemes with a low Beta. It ensures a stable investment during a volatile stock market.
Other Parameters to Measure Risk-Adjusted Returns
R-squared:
It is a statistical tool that helps investors compare a fund’s performance to its benchmark. A higher R-squared implies that the fund’s performance moves more in sync with its benchmark. This measure tells you how closely a mutual fund scheme tracks its index or benchmark.
Standard Deviation
In statistics, standard deviation tells you how different a measured value could be from its mean or average. In mutual funds, standard deviation indicates how different the actual returns could be from expected returns based on the historical performance.
Sharpe Ratio
Sharpe Ratio is also based on the standard deviation measure to gauge the risk-adjusted performance of a mutual fund scheme. This ratio indicates how much excess returns a mutual fund scheme has generated as compared to risk-free investments such as government securities. Knowing the Sharpe Ratio will tell you if the returns generated by a mutual fund scheme are due to assuming higher risk or making excellent investment decisions. The higher the Sharpe Ratio, the higher the risk-adjusted returns generated by the mutual fund scheme.
Conclusion
Investors must know the various parameters to gauge mutual fund performance. Measuring risk-adjusted returns is a better approach as they indicate how well your investment has performed compared to the market and every unit of risk assumed. Moreover, you must study the investment style of the fund manager and opt for mutual funds that match your risk profile.
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