Mutual fund performance ratios: Alpha, Beta, SD & Sharpe ratio

Imagine you are choosing a house. Sure, the size, amenities, and surroundings are attractive, but for a wise choice, you consider factors like property age, condition, and budget. Similarly, when investing in mutual funds, their past performance is crucial. But how do you analyse that performance effectively? 

Enter the world of mutual fund performance ratios: 

• Alpha, 
• Beta, 
• Standard Deviation (SD), and 
• Sharpe Ratio 

These are performance metrics that help you assess a fund’s risk-reward potential.

Why are mutual fund performance ratios important?

Mutual funds are investment vehicles that make diversification and professional management possible by collecting funds from people and investing in a basket of securities. 

However, various mutual funds on hand make it complicated to pick out the right one.

When choosing a fund, don’t just look at past returns. Consider how the fund performs compared to its costs, which is the mutual fund performance versus expense ratio. A lower expense ratio means less money outgo. 

Also, simply looking at the returns can be misleading – this is where mutual fund performance ratios step in. 

These ratios consider the returns a fund generates and the risk involved in achieving them, which makes them a viable choice. It also assists in comparing different funds. 

Ratio 1: Alpha

What alpha does is measure how a fund outperforms its benchmark index, for example, the Sensex. Think of it as the extra return made by a fund/scheme after taking into account the movement and risk of the market generally.

Assume that a large-cap mutual fund has given an annual return of 12%, whereas Sensex has offered 10%. This fund has an alpha of 2%. That means the fund manager has outperformed the benchmark by 2%.

The baseline for alpha is zero. An alpha above zero would imply that a fund is better than its relevant benchmark, while if it equals zero, then it means that mutual funds perform at par with their benchmark indices. On the contrary, a negative alpha would show that a fund underperformed compared to its benchmark. 

Positive alpha signals skill on the part of the portfolio manager, who may either be good at picking stocks or timing markets. In contrast, a negative alpha could be because of poor investment decisions or high fees. 

Also read: What is alpha and beta in the stock market? 

Ratio 2: Beta 

The mutual fund ratio, beta, measures how sensitive a mutual fund scheme’s return is to market movements. In simple terms, it shows how a mutual fund scheme’s returns change in response to market changes. 

• If beta is 1 – it implies that the mutual fund performance is in line with the market. 
• If the beta is greater than 1 – it indicates higher volatility and 
• A beta less than 1 – shows lower volatility. 

Think about a mutual fund having a beta of 1.2. This means that, in this case, if the market goes up by 10%, this is how returns will move: 

Must read: Beta in stock markets: The risk factor in portfolio management  

Ratio 3: Standard deviation (SD)

If we talk about volatility – one ratio comes to mind, that is standard deviation. This ratio is independent of any benchmark and measures volatility. In simple terms, it shows how much a mutual fund scheme’s return deviates from its average return (over a period). 

If, for instance, a mutual fund scheme has a standard deviation of 4 while its expected return is 15%- it tells us that the fund’s return can vary on either side (+4 or -4).

The higher the SD, the bumpier the ride. A high SD means the fund’s returns might swing way above or below (the direction is not fixed) its average in a given year. This can be risky because it means there’s a bigger chance of losing money.

Ratio 4: Sharpe ratio    

The Sharpe Ratio tells you how much extra return you get for each unit of risk you take on.

The formula is:  

Sharpe Ratio = (Average Return of Scheme  – Risk-Free Rate) / Standard Deviation of Scheme 

For instance:

• A mid-cap fund’s return = 12% p.a. 
• SD = 20% and 
• The risk-free rate = 5%, 

So, Sharpe Ratio = (12% – 5%) / 20% = 0.35

Hence, it can be inferred that for every additional unit of risk, this fund returns an extra yield of 0.35%. 

You may also like: What is the annualised rate of return? Learn the formula & calculation 

Conclusion

Understanding these mutual fund performance ratios offers essential insights into how a mutual fund has performed. But remember – these ratios are historical indicators and should not be the sole basis for your investment decisions.

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