What Are Mutual Fund Ratios and Why Investors Use Them?

12 min read • Updated 11 May 2023
Written by Team Wint Wealth
What is Mutual Fund Ratios and Why They are Important

The number of mutual fund investors in India continues to rise as more and more people become increasingly aware of its benefits. Generally, people assess the past performance of a mutual fund scheme before investing their money in it. 

However, evaluating the risks associated with a fund is equally important. Various ratios quantify the risks of a particular mutual fund scheme. People can use these mutual fund ratios to understand a fund’s performance better.

A Detailed Look at the Mutual Fund Ratios 

Given below are the details of various mutual fund ratios: 

  1. Alpha

This ratio denotes how a fund has performed compared to its benchmark index. In other words, alpha denotes how well a fund manager has been able to manage a fund. Based on the fund manager’s performance, an actively managed fund will have a positive or negative alpha.

The baseline for alpha is 0. If a fund’s alpha is greater than 0, it indicates that the fund is performing better than its underlying benchmark. If it is 0, the mutual fund performs the same as its benchmark index. Conversely, a negative alpha reflects a fund’s underperformance compared to its benchmark.

Let us use an example to understand this. For example, suppose the NIFTY 50 index generated 13% in the previous year. If a mutual fund with NIFTY 50 as its underlying benchmark delivered 10%, its alpha will be -3%. It means that the fund has underperformed its benchmark by 3%.

The formula for calculating a mutual fund’s alpha is:

Alpha = (End Price + DPS – Start Price) / Start Price. Here, DPS stands for distribution per share.

  1. Beta

This mutual fund ratio is used to assess how a fund responds to market fluctuations. Simply put, beta measures the variations that a fund displays in response to market fluctuations as reflected by its benchmark index. Investors can check a fund’s beta to know its stability/sensitivity in a volatile market.

The baseline for beta is 1 in mutual funds. So, if the beta is greater than 1, it tells us that a mutual fund is more volatile than its benchmark index. In other words, the fund is more sensitive to market fluctuations. 

If the beta value is less than 1, it indicates that this mutual fund shows lesser variations in response to market fluctuations than its benchmark index. When beta is equal to 1, a mutual fund will show the same variation as its benchmark index. 

For example, suppose the beta of a mutual fund is 1.5. This shows us that the fund is 50% more volatile than the benchmark index (say Nifty 50). Now, if Nifty 50 goes up by 5%, the fund’s beta will go up by 7.5% (1.5 x 5%).

The formula for calculating a fund’s beta value is (Covariance / Variance of market returns). Here, covariance depicts performance changes of two different stocks in changing market conditions.

  1. Sharpe ratio

If an individual wishes to get higher returns, he or she may have to take a higher risk. The Sharpe ratio is an essential mutual fund risk ratio that investors can check to find if these risks are worth taking.

One can use this ratio to understand a fund’s potential to generate risk-adjusted returns. The greater a portfolio’s Sharpe ratio, the better its risk-adjusted performance.

While the Sharpe ratio is an important factor that helps us understand fund performances, one should not study it in isolation. An investor needs to study the Sharpe ratio along with a fund’s standard deviation to get a clearer picture. 

The formula for calculating Sharpe Ratio is as follows: 

Sharpe Ratio = Excess Returns (Average Returns – Risk-free Returns) / Standard Deviation of Fund Returns 

  1. Standard deviation 

Standard deviation is a mutual fund risk ratio that depicts the volatility or risk associated with a fund. It depicts how much a fund’s current returns have deviated from its average annual returns in the past. A high standard deviation means that there is high volatility, i.e. sharp fluctuations in a fund’s returns.

An important factor that investors must remember while checking a fund’s standard deviation is that its working depends on the law of averages. In other words, a fund’s standard deviation can be better understood and interpreted if it is compared with another fund’s. One can compare two mutual funds of a similar type using this data. 

Let us understand the working of standard deviation with an example. Suppose a mutual fund has a standard deviation of 4 and expected returns of 14%. It indicates that the fund returns tend to deviate by 4% on the higher side (it can generate 18% returns) and 4% on the lower side (it can generate 10% returns).

  1. Sortino ratio 

The Sortino ratio helps to determine a fund’s performance with respect to its downward deviation, especially during adverse economic conditions. When investors evaluate a fund’s Sortino ratio, they get a realistic picture of the downside risks associated with it. This mutual fund ratio helps to assess an investment’s risk-adjusted returns.

The primary difference between Sharpe ratios and Sortino ratios is that the latter takes into account only downside standard deviations for risk calculation and not the fund’s total volatility. Therefore, a higher Sortino ratio denotes a high potential for the fund to earn higher returns without taking unnecessary risks.

The following is the formula for calculating a fund’s Sortino ratio:

Sortino ratio = R – Rf / SD 

Here, R = Expected returns

Rf = Risk-free rate of returns

SD = Standard Deviation of the asset which delivered losses 

  1. R-Squared 

Investors can use the R-squared ratio to study how identical a mutual fund is to its benchmark index. It is measured on a scale of 1 to 100. A higher R-squared value indicates a scheme’s higher correlation with the benchmark index. For instance, if the R-squared value is 100, it indicates that the scheme correlates perfectly with its benchmark index. 

Note that index funds tend to have a higher R-squared value. However, actively managed mutual funds can have different R-squared values. For example, a scheme whose R-squared value is 80 or less is not designed to perform like the benchmark index.

However, if an actively managed fund has a high R-squared value, it may have been designed like its underlying index. Generally, a fund with an R-squared value of up to 40% shows little correlation with the benchmark. An R-squared value of 40% to 70% denotes average correlation, while an R-squared value of above 70% shows a high correlation.

To calculate the value of R-squared, one needs to consider other metrics such as correlation and standard deviation. Given below is the formula to calculate the R-squared value:

R-squared = Square of correlation

Correlation = Covariance between benchmark index and portfolio / (SD of portfolio * SD of benchmark index)

SD = Standard Deviation 

  1. Treynor Ratio 

The Treynor ratio measures the excess returns that all securities or financial assets in a scheme earn for every unit of risk taken by the entire portfolio. In other words, it depicts a fund’s risk-adjusted performance and can be used by potential investors to shortlist mutual funds. 

The Treynor ratio measures performance based on the systematic risks of an investment as opposed to its standard deviation, unlike Sharpe ratio. This mutual fund ratio allows investors to understand whether it will be worth taking risks involved in investing in a particular scheme and how much returns they could get. 

Moreover, it also helps us understand how well a fund manager can maintain a balance between risk and returns. An investor needs to know a fund’s beta to calculate the Treynor ratio. Given below are the details of its calculation: 

Treynor Ratio = (Portfolio’s Returns – Risk Free Return Rate) / Beta of the Fund 

  1. Information ratio

This is a mutual fund ratio that depicts how consistently a fund has generated good risk-adjusted returns. It gives information on a fund manager’s ability to consistently generate superior risk-adjusted returns and can be used to compare multiple funds with similar management styles.

According to financial experts, the information ratio is an advanced version of the Sharpe ratio. It informs investors about how much extra returns a fund has generated with respect to the excess risk taken based on its underlying benchmark.

While calculating the Sharpe ratio, you have to divide excess returns by standard deviation. To calculate the information ratio, you must divide the active returns of a fund’s portfolio by tracking error. Tracking error is the standard deviation calculated from the difference between a fund’s returns and its underlying index’s returns. Given below is its formula:

IR (Information Ratio) = (Portfolio Rate of Returns – Benchmark Rate of Returns) / Tracking Error 

  1. Expense ratio

Another important ratio that investors should consider before investing in a mutual fund is the scheme’s expense ratio. It is the amount an investor must pay to the AMC (Asset Management Company) for managing his investments. 

It is a yearly fee that is charged on a per-unit basis for all expenses borne by the AMC, including fund manager’s salary, administrative costs, operating costs, marketing costs, etc. A higher expense ratio corresponds to lower returns. So, as an investor, you will want to choose a fund charging a lower expense ratio.

Note that people do not have to pay expense ratio separately. It is calculated as a percentage of the fund’s NAV (Net Asset Value) on a particular day. The formula for expense ratio calculation is as follows:

Expense Ratio = (Total expenses borne by the mutual fund) / (Average Assets under Management)

Why Should You Analyse Mutual Fund Ratios? 

Analysing the mutual fund ratios allow an investor to track the performance of a mutual fund. One can assess a scheme’s fund fact sheet to get accurate information on these metrics.

But first, let us take a look at why it is necessary to monitor a mutual fund’s performance: 

  • A fund’s performance is subject to market situations, i.e. changing dynamics of the market affect mutual fund returns. So, investors need to monitor the returns from mutual fund investments to ensure that they align with their financial goals.
  • A change in fund managers, mutual fund’s investment objective or asset allocation, may have a significant impact on one’s investment. This impact may no longer align with an investor’s financial goals. As a result, the investor may have to rebalance his/her investment portfolio and, in some cases, reconsider their investments. It is advisable to regularly track a mutual fund’s performance. 
  • An important factor that investors must remember is that if a fund has performed well in the past, it does not guarantee similar returns in the future. Therefore, considering factors like the fund manager’s expertise, the fund’s performance against its benchmark and asset allocation is important to understand its overall performance. 

How Frequently Should You Analyse a Mutual Fund’s Performance? 

Detailed below is important information about how frequently you need to check your mutual fund’s performance:

  • There is no fixed rule regarding how often an investor should assess a fund’s performance. Though mutual fund investments are subject to market risks, daily evaluation of a fund’s performance is not required.
  • Another important factor determining the frequency is an investor’s financial goal and portfolio composition. For instance, assessing the performance of a scheme every six months is a good idea if the person has invested in an equity fund for a long investment horizon. He can review it more often as his investment tenure comes to an end.
  • However, if an investor has made a short-term investment, it is a good idea to evaluate fund performance more frequently. In that case, it is important to check the quality of the portfolio, market rates and the fund’s short-term performance.

Many people stay away from mutual fund investments assuming it’s very difficult. But it should not be so. Once you have formulated your investment goal and time frame based on your risk profile, shortlist a few schemes. Then, evaluate the mutual fund ratios for each of these funds and ultimately choose one aligned with your financial goals.

Frequently Asked Questions 

What is a fund fact sheet? 

A mutual fund fact sheet is a document issued by the AMC which provides an overview of a scheme’s performance. Important components of this document are annualised returns, associated risks, investment objectives, and fees. It also shows the different mutual fund ratios, which helps investors to keep track of their investments. 

What are the important parameters for selecting a mutual fund scheme?

Some important parameters while selecting a fund are expense ratio, risk level, fund manager, fund’s history, portfolio turnover ratio, investment objective. The fund’s historical performance with respect to its benchmark index is also important.

What are a fund’s annualised returns, and why is it important? 

Annualised returns refer to the rate of return on an investment or a portfolio of investments over a period of one year. It is calculated by taking the total return (including any income and capital gains) and dividing it by the initial investment or the average value of the investment over the period in question.
Annualised returns are important because they provide a standardised way to compare the performance of different investments over time. For example, an investment that has returned 10% over a period of six months would have an annualised return of 20%. This allows investors to easily compare the performance of different investments, regardless of the length of the investment period. Additionally, annualised returns can also be used to calculate the expected return of an investment over a longer period of time, such as several years.

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