There are many ratios that you can use to evaluate a mutual fund. However, not all of them are equally useful. According to experts, the below mentioned 5 basic ratios may be used to analyze any mutual fund. However, If there are still any doubts about your fund selection, you always check with the additional ratios.
Standard Deviation is the most widely used measure of calculating the risk involved in a mutual fund. Standard Deviation is basically the square root of variance.
Standard Deviation is given by the following formula:
In this case, x is each individual value (say, monthly return). X (bar) is the average of the values (such as the monthly return average). N would be the number of months (60, for example, if we are looking at a 5 year period).
A high standard deviation indicates the involvement of higher risk in the fund and vice versa. For instance, the standard deviation of HDFC Equity Fund is 18.49% while the standard deviation of HDFC Hybrid Equity Fund is 11.41%. The standard deviation of HDFC Liquid Fund is just 0.21%. In a normal statistical distribution, approximately 95% of observations fall within 2 standard deviations. This means that you would expect returns of HDFC Liquid Fund to give returns within 0.42% of its average value of 6.89%, with a 95% probability. However, this only holds true if the mutual fund returns follow a standard deviation.
This ratio refers to the percentage of a mutual fund’s assets which have been bought/sold in the previous year. For example, a turnover ratio of 50% means that a Mutual Fund has bought/sold stocks equal to 50% of its average assets.
A high turnover ratio can mean that the fund manager is frequently changing his strategies and incurring high transaction costs (buying and selling transactions involve brokerage and other costs). Thus, a high turnover ratio is usually viewed as a negative factor.
Alpha or Jensen’s Alpha is the degree with which a mutual fund is outperforming its benchmark adjusted to its risk level. For example, if the fund is benchmarked to the Nifty 50 which has given 10% returns and the fund delivers a return of 12%, it would have an alpha of 2%.
A high alpha implies that the fund is outperforming. On the other hand, a low or negative alpha indicates the poor performance of a fund.
This ratio gives the sensitivity of the mutual fund to the market. The higher the beta, the more sensitive the fund is. For example, a beta of 2 indicates that for every 1% move in the market, the fund’s NAV will move by 2% on average.
A high beta fund can imply both higher risk and higher return (and vice versa for a low beta fund).
This ratio incorporates both risks and returns. It gives you an idea of the return delivered by a fund compared to the risk it is dealing with. For example, some funds may deliver higher returns only by taking higher risk. Such returns should be viewed with more skepticism than the funds which give high returns while taking a low level of risk. Mathematically, the Sharpe ratio divides the outperformance generated by a fund compared to the risk-free rate with the volatility of the fund.
A high Sharpe ratio indicates high return for a given risk level. This is a highly desirable quality in a fund and hence, mutual fund schemes with higher sharpe ratios should be preferred.