How can you evaluate the risk of your mutual fund?

Today, we’ll discuss key metrics to evaluate a mutual fund’s risk.

The Story

In recent years, the popularity of mutual funds among individual investors and institutions has grown drastically, making them one of the preferred ways of investing in the capital markets.

SIP contribution has been reaching all-time highs, crossing ₹26000 crore mark for the first time in December 2024.

It has become increasingly important to for investors to not just look at past returns but also focus on risk analysis.

Let us dive into the four most critical risk and risk-adjusted return ratios every investor ought to know.

1. Standard Deviation

The standard deviation shows the total volatility of a fund. It measures how much the returns of an investment move away from the average (or expected) return.

Let’s take an example of two mutual funds.

The higher the standard deviation of the mutual fund scheme, the higher the volatility and vice versa. Greater volatility translates to greater risk.

So based on the metric, Quant’s Midcap Fund is riskier compared to Motilal’s.

2. Sharpe Ratio

Sharpe is the measure of assessing risk-adjusted returns. Continuing with the same funds:

Sharpe Ratio
Quant Midcap Fund: 1.06
Motilal Oswal Midcap Fund: 1.73

Here, a Sharpe ratio of 1.06 means for every unit of risk (measured as the standard deviation) your investment takes, it generates 1.06 units of excess returns. So, the higher, the better.

In our example, M.O. Midcap Fund is generating higher risk-adjusted returns.

3. Beta

Beta is one of the simplest measures of risk. It reflects a fund’s sensitivity or relative risk compared to its benchmark. It indicates how a fund’s returns are likely to fluctuate in response to market movements.

Beta
Quant Midcap Fund: 0.97
Motilal Oswal Midcap Fund: 0.83

A beta of 0.83 means that for every 1% move in the market (Nifty 50 or Sensex), the fund moves 0.83%. A beta higher than one indicates that the fund is more volatile than the market.

Similarly, a beta of less than one means the fund is less volatile than the market. And when beta = 1, it means that the fund moves in line with the market.

4. Jensen’s Alpha

Alpha (Jensen’s Alpha) gives an insight into how a fund is performing relative to the benchmark, where risks are taken into consideration.

It reflects the extra returns or excess returns that the fund generates due to good stock and sector selection by the fund manager while maintaining low volatility. (Now you might have guessed why we have named our newsletter “Alpha”)

A positive alpha indicates the fund has outperformed its benchmark after accounting for risk, while a negative alpha means the fund has underperformed on a risk-adjusted basis.

To Conclude

Well, there’s a popular saying in investing: you can not control the returns of your investment, but you can always control how much risk you want to take.

Incorporating risk metrics helps you to go beyond surface-level returns and make well-informed decisions. So, the next time you evaluate a fund, don’t just ask, “What’s the return?” but also, “At what risk?”