How to calculate Mutual Fund Risk

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We know that shares carry a risk but are mutual funds also risky? Well any investment
decision has to carry a certain amount of risk-doesn’t it? So, it means that mutual funds
also carry a risk profile with them. So how do you assess your mutual fund’s risk profile?
Some of the tools available to assess your scrip’s riskiness can also be used to assess a
mutual fund's risk (or its close cousin, volatility).

Beta
This common measure compares a mutual fund's volatility with that of a benchmark and
is supposed to give some sense of how far you can expect a fund to fall when the market
takes a dive, or how high it might climb if the bull is running hard. A fund with a beta
greater than 1 is considered more volatile than the market; less than 1 means less volatile.
So say your fund gets a beta of 1.15 -- it has a history of fluctuating 15% more than the
benchmark If the market is up, the fund should outperform by 15%. If the market heads
lower, the fund should fall by 15% more.

But beta, though a useful guide, is far from perfect, especially when used as a proxy for
"risk." The problem here, as with many risk measures, is the benchmark. The benchmark
has to be a correct measure of comparison only then will the beta hold any indicative
value.

Alpha
Alpha was designed to take beta one step further. It looks at the relationship between a
fund's historical beta and its current performance, or the difference between the return
beta would lead you to expect and the return a fund actually gets. An alpha of 0 simply
means that the fund did as well as expected, considering the risks it took. So if that fund
with the beta of 1.15 beat the market by 15% (or underperformed it by 15% when the
market was down), it would have a 0 alpha. If your fund has a positive alpha, that means
it returned more than its beta predicted. A negative alpha means it returned less. The
trouble with alpha is that it's only as good as its beta. If the benchmark isn't appropriate to
a fund in deriving its beta, then alpha, too, will be imprecise.

Standard Deviation
Meet the most popular of the risk measures -- one with a distinct advantage over beta.
While beta compares a fund's returns with a benchmark, standard deviation measures
how far a fund's recent numbers stray from its long-term average. For example, if Fund X
has a 10% average rate of return and a standard deviation of 5%, most of the time, its
return will range from 5% to 15%. A large standard deviation supposedly shows a more
risky fund than a smaller one. But here, again, what's problematic is your reference point.
The number alone doesn't tell you much. You have to compare one standard deviation
with the others among a fund's peers. But a more glaring problem is that the standard
deviation system rewards consistency above all else. A fund is considered stable based on
the uniformity of its own monthly returns. So if it loses money but does so very
consistently it can have a very low standard deviation -- down 3% each and every month
wins a standard deviation of zero. And likewise, a fund that gains 10% one month and
15% the next would be penalized by a high standard deviation -- a reminder that
volatility, although perhaps a cousin to risk, itself isn't necessarily a bad thing.

Sharpe Ratio
This formula, worked by Nobel Laureate Bill Sharpe, tries to quantify how a fund
performs relative to the risk it takes. Take a fund's returns in excess of a guaranteed
investment (a 90-day T-bill) and divide by the standard deviation of those returns. The
bigger the Sharpe ratio, the better a fund performed considering its riskiness. Here, again,
you have the problem of relativity -- the ratio itself doesn't tell you anything, you have to
compare it with the Sharpe of other funds. But this ratio has an advantage over alpha
because it uses standard deviation instead of beta as the volatility variable, and therefore
you don't have to worry that a fund doesn't relate well to the chosen index.

Overseas, one has mutual fund rating companies - like Morning Star which provide views
of risk. Morningstar says that what we investors really care about is when our funds
LOSE money, not when they're doing better than the benchmark or than their long-term
averages. It measures how often and by how much a fund trails the monthly T-bill rate,
and then compares that average loss with that for the investment class. The average for a
class is 1.00, so numbers above that mean a fund is riskier than its peers, and below is
considered less risky.

In India we still have to introduce this kind of a risk rating. However till then remember
one needs to be conscious of risk, but not push it to the last decimal point. It's about
awareness, rather than mathematics.

Aru Srivastava

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