How to measure the risk of your mutual fund portfolio
You must have heard this line in all mutual fund advertisements. “Mutual fund investments are subject to market risks, read all scheme related documents carefully.” Then you may wonder why you should invest in mutual funds. The reason you are investing in mutual funds is because they invest in diversified portfolio of shares and securities. Moreover, professional fund managers are managing your money and you bear fund management changes for that. Then where does the risk come in?
Yes, investment in mutual funds is lesser risky than investing in direct stocks but that doesn’t mean that mutual funds entail no risk. The very nature of investment instruments that your pool of money gets invested in are subject to periodic movements. Share prices change each minute, debentures are dependent on the yields and the papers available during a particular period and deposit rates change with the company and time. As a result no mutual fund can promise returns that it will deliver. Nobody can precisely predict the market movements. So when share prices across the board are plunging your equity-mutual-fund performance will be bleak, when companies are faltering on deposit payments the mutual fund scheme will suffer too. Though professional fund management ensures reduction of stock-specific risk, there are several other risks that mutual fund schemes still have to deal with and here are three different ratios, which will help you measure the risk quotient of your portfolio.
1) Beta
It measures volatility of a particular mutual fund in comparison to the market as a whole. A beta of 1.0 indicates that the NAV of the mutual fund will move in the same direction as that of benchmark index. If the Nifty goes up, so will the NAV of the mutual fund that has Nifty as it benchmark. Similarly, if the markets go into a tailspin, the NAV of the fund will also fall. If the beta is lesser than 1.0 indicates that the fund NAV will be less volatile than the benchmark index. On the other hand, a beta of more than 1.0 indicates that the investment style of the mutual fund is aggressive and more volatile than the benchmark index. If you are an aggressive investor, you can opt for these funds as they move up more than the benchmark, but the fall will also be steeper. If you are a conservative investor and prefer low risk investments, you should consider mutual funds schemes with low beta.
2) R-Squared
Beta cannot be considered as a standalone measure, it needs to be considered along with ‘R-squared’, which measures the correlation between beta and its benchmark index. The combination of these two statistical measures helps you understand the risk of a mutual fund more accurately. Typically, ‘R-squared’ values falls in the range between 0 and 1, where 0 represents no correlation and 1 represents full correlation. The lower the R-squared, less reliable is the beta, and vice versa. In other words, the beta of a fund has to be trusted only if the R-squared value that is between 0.75 and 1. If the R-squared value is lesser than 0.75, it indicates the beta is not particularly useful as the fund is being compared against an inappropriate benchmark index. This fund will not mirror the returns of that of its benchmark index.
R-squared of an index fund, which is investing in the same securities and in the same weightage as the underlying benchmark index, will be one. Given that Beta and R-squared are calculated on the basis of historical data, it makes sense to consider Beta and R-squared before investing.
3) Standard Deviation (SD)
Standard deviation measures the volatility of a mutual fund by saying how much the return on a fund is deviating from the expected returns based on its historical performance. It computes the total risk, which includes market risk, security-specific risk and portfolio risk of a mutual fund.
In simple words, standard deviation tells you how consistent is the performance of your mutual fund over a period of time. Higher the SD, higher is the volatility of net asset value (NAV) of the mutual fund and riskier is your investment. However, you should use SD only when you compare a mutual fund with its peer group mutual funds. For instance, you should compare SD of a large cap fund with another large cap fund and not with a mid-cap or a small-cap fund.
