Investing in mutual funds involving an active role of a fund manager is set to be one of the safest investment avenues as regards the high risk/return equity investment. Being assumed safe and the onus entrusted to fund managers, it is perceived that investors give a cursory glance at the performance sheet of the fund, gain some money, and carry on with their investments with the fund.

However, though they make money from the fund, a detailed examination of the fund?s performance in relation to other risk-free investment avenues and the Benchmark index gives telling insights into the fund?s performance. A comparison with risk-free investments like government securities, treasury bills, and also the Benchmark index would determine how safer and more profitable your fund is.

Here is an analysis of the ratios that can help you gauge the performance of your fund as regards investing in less riskier investment avenues.

Standard Deviation

Standard deviation throws light on a fund?s volatility in terms of rise and fall in its returns. Maximum volatility in a security is the riskiest, considering the unevenness it brings about in its performance. Standard deviation of a fund measures this risk by measuring the degree to which the fund fluctuates in relation to its mean return. That is the average return of a fund over a period of time.

A fund that has a consistent four-year return of 3%, for example, would have a mean or average of 3%. The standard deviation for this fund would then be zero because the fund?s return in any given year does not differ from its four-year mean of 3%. On the other hand, a fund that in each of the last four years returned -5%, 17%, 2% and 30% will have a mean return of 11%. The fund will also exhibit a high standard deviation because each year the return of the fund differs from the mean return. This fund is therefore riskier because it fluctuates widely between negative and positive returns within a short period.

To determine how well a fund is maximising its returns received for its volatility, you can compare the fund to another with a similar investment strategy and similar returns. The fund with the lower standard deviation would be more optimal because it is maximising the return received for the amount of risk acquired.

Sharpe ratio

This ratio describes how much return you are receiving for the extra volatility that you endure for holding a riskier asset. Remember, you always need to be properly compensated for the additional risk you take for not holding a risk-free asset.

It is defined as S(x) = (rx-Rf)/Std dev(x)

Where ?x? is the investment,

?rx? is average rate of return of x

Rf is the best available rate of return of a risk-free security like government securities

Std dev(x) is the standard deviation of rx.

Sharpe ratio is a risk-adjusted measure of return that is often used to evaluate the performance of a portfolio. The ratio helps to make the performance of one portfolio comparable to that of another portfolio by making an adjustment for risk. For example, if manager A generates a return of 15% while manager B generates a return of 12%, it would appear that manager A is a better performer. However, if manager A, who produced the 15% return, took much larger risks than manager B, it may actually be the case that manager B has a better risk-adjusted return.

To continue with the example, say that the risk free-rate is 5%, and manager A?s portfolio has a standard deviation of 8% (considering high risk/return), while manager B?s portfolio has a standard deviation of 5%.

The Sharpe ratio for manager A would be 1.25 while manager B?s ratio would be 1.4, which is better than manager A. Based on these calculations, manager B was able to generate a higher return on a risk-adjusted basis. A ratio of more than or equal to 1 is good, more than or equal 2 is very good, and more than or equal 3 is excellent.

Sharpe ratio is broken down into three components: asset return, risk-free return, and standard deviation of return. After calculating the excess return, it?s divided by the standard deviation of the risky asset to get its Sharpe ratio. The idea of the ratio is to see how much additional return you are receiving for the additional volatility of holding the risky asset over a risk-free asset – the higher the better.

Sortino Ratio

Sortino Ratio was developed by Frank A Sortino to differentiate between good and bad volatility in the Sharpe ratio. This differentiation of upwards and downwards volatility allows the calculation to provide a risk-adjusted measure of a security or fund?s performance in a clearer and comprehensive way. It doesn?t misses on the upward price changes and unlike standard deviation it doesn?t discriminate between up and down volatility.

The Sortino ratio is similar to the Sharpe ratio, except it uses downside deviation for the denominator instead of standard deviation.

Beta

Beta determines the volatility, or risk, of a fund in comparison to that of its index or benchmark. A fund with a beta very close to 1 means the fund?s performance closely matches the index or benchmark. A beta greater than 1 indicates greater volatility than the overall market, and a beta less than 1 indicates less volatility than the benchmark.

If, for example, a fund has a beta of 1.05 in relation to the Sensex, the fund has been moving 5% more than the index. Therefore, if the Sensex has increased 15%, the fund would be expected to increase 15.75%.

On the other hand, a fund with a beta of 2.4 would be expected to move 2.4 times more than its corresponding index. So if the Sensex moved 10%, the fund would be expected to rise 24%, and, if the Sensex declined 10%, the fund would be expected to lose 24%.

You can choose funds exhibiting high betas, which increase your chances of beating the market. Also if the market is bearish the funds that have betas less than 1 are a good choice because they would be expected to decline less in value than the index. For example, if a fund had a beta of 0.5 and the Sensex declined 6%, the fund would be expected to decline only 3%. However, you must note that beta by itself is limited and there may be factors other than the market risk affecting your fund?s volatility.

Treynor Ratio

Treynor ratio, developed by Jack Treynor, measures returns earned in excess of that which could have been earned on a riskless investment per each unit of market risk.

Treynor ratio is calculated as:

(Average Return of the Portfolio – Average Return of the Risk-Free Rate) / Beta of the Portfolio

In other words, the Treynor ratio is a risk-adjusted measure of return based on systematic risk. It is similar to the Sharpe ratio with the difference being that the Treynor ratio uses beta as the measurement of volatility. It is also known as the ?reward-to-volatility ratio?

What you should follow

As an investor it is important that you use a combination of these ratios to assess the performance of your fund. Because gauging the performance of your fund considering one ratio wouldn?t give you a clearer and correct picture of your fund?s performance. It is also important to remember that volatility is only one indicator of the risk impacting your fund.

A stable past performance of a fund is not necessarily a guarantee of its future stability. Unforeseen market factors can influence volatility and hence a fund that this year has a good performance may fare differently in the following year.