IF you have remained undecided about your fund manager after looking at the 18 per cent return notched up by your equity fund in the past two years, help is here.
Sharpe ratio
Sharpe ratio, which measures whether the returns notched up by a mutual fund portfolio are due to smart decisions or excessive risk. Sharpe ratio measures risk-adjusted performance as a fund can reap higher returns than its peers by taking too much additional risk.
Mathematically, the ratio is derived by subtracting the risk-free rate from the rate of return of a portfolio and dividing the result by the standard deviation of portfolio returns.
The greater this ratio, the better its risk-adjusted performance has been. For example, Birla Sun Life Dividend Yield Plus, which has given 18.49 per cent returns in three years, has a Sharpe ratio of 0.56. In comparison, ING Dividend Yield's three-year return of 18.37 per cent has come with a Sharpe ratio of 0.52, according to Value Research data, which uses SBI fixed deposit rate for 46-90 days as risk-free rate.
A fund consists of stocks, which may also move up due to the overall market movement. Alpha helps find out what portion of a fund's return can attribute to the fund manager's skill rather than market movement.
Alpha
A positive alpha implies that a fund manager has added value over and above the market performance. On the other hand, a negative alpha could indicate that the manager has reduced value of the fund by underperforming the market. The conventional way of calculating alpha — which is the most basic measure of a fund manager's contribution to investment yield — is to deduct the benchmark's percentage return from the fund return.
Note that alpha can be either inflated (when the market is up) or deflated (when the market is down) by the percentage change in the benchmark itself. "To benefit from alpha, it should be taken for three years," said Hiren Dhakan, an associate fund manager with Bonanza Portfolio.
Of course, the alpha measure is only as good as the beta used to compute it.
Beta
Beta measures volatility of a portfolio in comparison with the broader market. A beta of 1 indicates that the portfolio value will move with the market. A beta of less than 1 could mean that the portfolio will be less volatile than the market.
Many portfolios with utilities could have a beta of less than 1. However, a technology-oriented portfolio will have a beta of greater than 1, offering the possibility of higher rate of return with more risk.
Beta measures volatility of a fund portfolio in comparison with the broader market. A beta of 1 indicates that the portfolio value will move with the market.
RSquared
Another indicator is RSquared, which measures how closely your fund manager's returns match the returns of the benchmark against which it is compared.
Like others, the tool is not for selecting a fund, but for evaluation of performance. So, if a mid-cap fund has an RSquared of 40 per cent, it indicates very little correlation with the chosen benchmark. While straying from your benchmark is not bad, it should be matched with risk-adjusted returns.
Standard Deviation
Standard deviation measures how much the return on the fund is deviating from the expected normal returns. As an investor you should be worried if the return of your pharma fund is very high or very low from expected returns (based on historical data). Peer comparison is a must. For instance, two mutual funds where one gained and the other lost 1 per cent each and every month over the past 36 months will both have a standard deviation of zero, because its monthly returns didn't change from one month to the next.
