Choosing a mutual fund based on returns alone is like buying a car just because it’s fast. But what about its mileage, safety, and handling? To truly understand a fund’s performance, you need to look at key mutual fund ratios. These metrics help you measure a fund’s risk-adjusted return—how much return it generated for the amount of risk it took. While metrics like CAGR vs. Absolute Return give you a good starting point, they don’t tell the whole story. To truly understand a fund’s performance, you need to look at key mutual fund ratios.
This guide will break down the most important mutual fund ratios with simple formulas and practical examples, turning you into a much smarter investor.
The Building Blocks: Risk-Free Rate, Standard Deviation & Beta
Before we get to the formulas, let’s quickly define the key ingredients:
- Risk-Free Rate (): The return you could get from a “zero-risk” investment, like a government bond. We’ll assume a Risk-Free Rate of 7% for all our examples.
- Standard Deviation (): This measures a fund’s total risk or volatility. A higher number means a bumpier ride.
- Beta (): This measures a fund’s market risk—its sensitivity to the overall market.
The Sharpe Ratio: The All-Rounder
The Sharpe Ratio is the most common metric for measuring return versus total risk.
- The Formula:
Where:
- = Return of the portfolio (the fund)
- = Risk-Free Rate
- = Standard Deviation of the portfolio
- Example: Let’s compare two funds, both giving a 15% return.
- Fund A: Has a Standard Deviation of 10%.
- Fund B: Has a Standard Deviation of 12%.
Calculation for Fund A:
Calculation for Fund B:
Conclusion: Fund A has a higher Sharpe Ratio. Even though both funds had the same return, Fund A was less volatile, making it the better risk-adjusted performer.
The Treynor Ratio: The Market Risk Specialist
The Treynor Ratio measures a fund’s return versus its market risk (Beta).
- The Formula:
Where:
- = Beta of the portfolio
- Example: Again, let’s take two funds with a 15% return.
- Fund C: Has a Beta of 0.9 (less volatile than the market).
- Fund D: Has a Beta of 1.2 (more volatile than the market).
Calculation for Fund C:
Calculation for Fund D:
Conclusion: Fund C has a higher Treynor Ratio. It generated better returns for the amount of market risk it took on.
Alpha: Measuring the Fund Manager’s Skill
Alpha tells you if the fund manager’s active management added any value compared to a benchmark index.
- The Formula:
Where:
- = Return of the market benchmark
- Example: Imagine a fund gave a 16% return (). The market benchmark (like Nifty 50) returned 14% (). The fund has a Beta of 1.1.
- Expected Return =
- This is the return the fund should have gotten based on its market risk.
Calculation for Alpha:
Conclusion: The fund manager generated a positive Alpha of 1.3%. Their skill delivered returns above and beyond what was expected for the risk taken.
Frequently Asked Questions (FAQ)
1. What is a “good” Sharpe Ratio? Generally, a Sharpe Ratio above 1 is considered good, above 2 is very good, and above 3 is excellent. However, it’s most useful for comparing similar funds.
2. Which is better: Sharpe or Treynor Ratio? Neither is “better,” they just measure different things. Use the Sharpe Ratio to compare funds with different diversification levels. Use the Treynor Ratio to compare well-diversified funds within the same category.
3. Why should I care about these mutual fund ratios? Because they force you to look at both sides of the coin: risk and return. Chasing high returns without understanding the associated risk is a common mistake. Using these ratios helps you make smarter, more informed investment decisions.
Disclaimer: The information in this article is for educational purposes only and is not intended to be financial or investment advice. All investments involve risk, and you should conduct your own research and consult with a qualified financial advisor before making any investment decisions.