6 Ways To Measure Mutual Funds Risk

Investing in Mutual Funds is a popular way to grow wealth, but it comes with its own set of risks. To make informed investment decisions it is crucial to understand these risks and how to measure them. This blog will explore the six key risk measures used in analysing the Equity Mutual Funds: Beta, Alpha, R-squared, Standard Deviation, Sharpe Ratio and Sortino Ratio.

What Makes Mutual Funds Risky?

In India, many people choose mutual funds to invest money. These offer decent returns but are a bit risky since they are market-linked investment instruments that focus on equities, corporate bonds, and debt securities, whose prices can fluctuate.

These fluctuations depend on factors like market trends, economic conditions, interest rates, and company performance. When these factors cause the NAV of the fund to drop, investors may face losses. However, understanding the risk level of a fund, its portfolio, and your own risk appetite can help you choose the right mutual fund and manage risk more effectively. 

Risk factors

Below are the various risk factors that you should know about:

• Market Risk: Mutual fund returns depend on market performance. If the stock or bond market falls, the fund’s NAV may also drop, leading to losses. Equity and hybrid funds are more sensitive to market swings.

• Interest Rate Risk: When interest rates rise, the value of existing bonds usually falls. This affects debt mutual funds the most, especially long-term bond funds. The longer the maturity of the bond, the more its price drops.

• Credit Risk: This risk arises when a bond issuer fails to repay the interest or principal. Lower-rated corporate bonds usually carry higher credit risk. Government bonds have the least credit risk.

• Liquidity Risk: Sometimes, the fund manager may find it hard to sell a security quickly without affecting its price. This makes it difficult to meet redemption requests or rebalance the portfolio in time.

• Price Volatility Risk: Equity mutual funds are prone to daily price fluctuations. The value of the underlying shares can rise or fall due to company performance or market sentiment, affecting your returns.

• Reinvestment Risk: When bonds in the fund pay interest or mature, the proceeds need to be reinvested. If interest rates have fallen, reinvesting at lower rates can reduce your overall returns.

• Prepayment Risk: In debt funds that invest in loans or bonds, borrowers may repay early when rates drop. This reduces expected income and may force the fund to reinvest at lower yields.

• Counterparty Risk: This risk refers to the possibility that the other party in a financial transaction may default. For example, they may fail to deliver securities or pay money owed.

• Event Risk: Company or industry-specific events like frauds, accidents, or regulatory changes can cause sudden declines in stock prices, impacting the value of equity mutual funds.

• Spread Risk: When the difference (spread) between corporate bond yields and government securities widens due to market conditions, it can reduce the market value of debt fund holdings.

Top 6 Methods to Measure Mutual Fund Risk

Risk essentially denotes the probability of an investor incurring losses, either partial or total, of the original investment. This risk arises from multiple sources, such as instability in the economy, shifts in the political scenarios and specific challenges within certain industries. These elements can significantly impact the performance of the Mutual Funds. Fortunately, the field of investment offers tools and metrics to measure these risks. By measuring and understanding these risks, investors are better equipped to make informed decisions, balancing potential returns against the likelihood of loss(es), thereby aligning their investment choices with their personal risk tolerance and financial goals.

1. Beta - Assessing volatility

Beta is a measure of the Mutual Fund's volatility relative to the overall market or a specific benchmark index. A Beta value of 1 indicates that the fund's price will move in sync with the market. A Beta greater than 1 signifies that the fund is more volatile than the market – it will experience larger fluctuations. Conversely, a Beta less than 1 suggests that the fund is less volatile. For conservative investors who prefer stability, funds with a low Beta are more attractive. However, it is important to remember that Beta is a relative measure and should be used as one of the several factors in investment decision making, not the sole criterion.

2. Alpha - Performance indicator

Alpha is a metric used to understand a Mutual Fund's performance relative to its benchmark index. It is not primarily a risk measure but is often used in conjunction with Beta. A positive Alpha indicates that the fund has performed better than its benchmark, suggesting effective management and strategy. A negative Alpha means the fund has underperformed in comparison to its benchmark. Positive Alpha is particularly appealing in actively managed funds as it reflects the fund manager's ability to generate extra returns above the benchmark. However, Alpha is based on the historical data and does not guarantee future performance.

3. R-Squared - Correlation with the benchmark

R-squared measures how closely a fund's performance correlates with its benchmark. It ranges from 0 to 100, where a score of 100 denotes perfect correlation. A high R-squared value in an actively managed fund may indicate that the fund's performance is very similar to its benchmark, suggesting a lack of unique strategy. Conversely, a lower R-squared might imply a more distinctive approach or divergence from the benchmark trends. This measure can be particularly useful in understanding the diversification benefits a fund might add to the portfolio.

4. Standard Deviation - Understanding volatility

Standard Deviation quantifies the variability or volatility of a fund's returns around its mean (average) return. A higher Standard Deviation indicates greater volatility and therefore, higher risk, as the fund's returns fluctuate more widely from its average. This measure is essential for understanding the level of uncertainty associated with a fund's return expectations. Risk-tolerant investors might prefer funds with higher Standard Deviations in pursuit of higher returns, while risk-averse investors may opt for funds with lower Standard Deviations for more predictable performance.

5. Sharpe Ratio - Risk-adjusted returns

The Sharpe Ratio evaluates a fund's risk-adjusted performance. It is calculated by subtracting the risk free rate of return from the fund's returns and then dividing this result by the fund's Standard Deviation. A higher Sharpe Ratio is generally preferable, indicating that the fund's returns are due to the wise investment decisions rather than excessive risks. It helps investors understand if the higher returns of a fund are adequate compensation for the additional risks taken.

6. Sortino Ratio - Focusing on the downside risk

The Sortino Ratio is similar to the Sharpe Ratio but with a key difference: it focuses solely on the downside or negative volatility of the fund. This makes the Sortino Ratio highly relevant for conservative investors who are more concerned about potential losses rather than the overall volatility. The ratio is calculated by subtracting the risk free rate from the fund's return and dividing it by the fund's downside deviation. A higher Sortino Ratio indicates a lower probability of large losses, making it a crucial tool for evaluating the risk of negative returns.

How Can You Minimise the Risk Involved in Investing in Mutual Funds?

• Diversify investments: To reduce mutual fund investment risks, start by diversifying, which means investing in a mix of equity, debt, and hybrid funds across various sectors and fund houses. This spreads your risk and balances returns.

• Take guidance to build a portfolio: Seek guidance from an expert professional who can help you build a portfolio that matches your goals and risk tolerance.

• Review portfolio frequently: Also, review your portfolio regularly. Once your target is met, shift from high-risk equity funds to stable options like debt funds.

Applying risk assessment measures in the fund selection

When choosing Mutual Funds, it is essential to align your selections with both your risk tolerance and investment objectives. If you are risk-averse, meaning you prefer stability over higher potential returns with associated risks, prioritise funds with a low Beta. A low Beta indicates that the fund is less volatile compared to the market. Additionally, seek out funds with a high Sortino Ratio. This ratio emphasises on the fund's ability to limit downside risk, which is particularly important if you are cautious about the potential losses.

Conversely, if you are inclined towards taking risks for getting higher returns, focus on funds with a high Alpha and Sharpe Ratio. A high Alpha suggests that the fund has historically outperformed its benchmark, signifying potentially higher returns. The Sharpe Ratio is equally crucial as it measures the risk-adjusted return; a higher ratio indicates that the fund's returns are more attributable to smart investment decisions rather than excessive risk taking.

Conclusion

Understanding and applying these six risk measures can significantly aid in selecting the suitable Mutual Funds. Remember, no single measure provides a complete picture. It is the combination of these metrics that will offer a comprehensive view of the fund's risk profile and potential performance.