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 that they invest in a diversified portfolio of shares and securities. Moreover, professional fund managers are managing your money, and you bear the fund management charges for that. Then, where does the risk come in?
Yes, investment in mutual funds is less 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 is 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, and when companies are faltering on deposit payments, the mutual fund scheme will suffer too. Though professional fund management ensures the 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 the 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 the benchmark index. If the Nifty goes up, so will the NAV of the mutual fund that has the Nifty as its benchmark. Similarly, if the markets go into a tailspin, the NAV of the fund will also fall. If the beta is less than 1.0 indicates that the fund’s 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 fund 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 fall in the range between 0 and 1, where 0 represents no correlation, and 1 represents full correlation. The lower the R-squared, the less reliable the beta, and vice versa. In other words, the beta of a fund has to be trusted only if the R-squared value is between 0.75 and 1. If the R-squared value is less 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 its benchmark index.
R-squared of an index fund, which invests 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 based on 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 showing how much the return on a fund deviates 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 the performance of your mutual fund is over a period of time. The higher the SD, the higher the volatility of the net asset value (NAV) of the mutual fund and the riskier 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 the SD of a large-cap fund with another large-cap fund and not with a mid-cap or a small-cap fund.