We are certain that you have calculated various ratios to track the performance of a company before making an investment decision. Making sound investment choices necessitates a comprehensive understanding of various financial metrics and ratios. Perhaps you have not yet calculated ratios for mutual funds to analyse performance. When it comes to mutual funds, analysing performance through specific ratios is crucial for estimating future returns and gauging the suitability of a fund for your investment goals. In this article, we’ll explore each key mutual fund ratio to empower you with the knowledge needed for informed investment decisions.
The average return is a fundamental metric that provides insights into the historical performance of a mutual fund. It is calculated as the mathematical average of returns over a specified period, such as 1, 2, 5, or 10 years. The formula for average return is Average Return = Sum of Returns / Number of Returns
The significance of average return lies in its ability to showcase the historical performance of an asset or fund. It provides investors with a snapshot of past returns, aiding in the assessment of a fund’s consistency over time. However, it’s important to note that the average return does not account for compounding.
Standard deviation is a statistical measure that quantifies the dispersion of a dataset relative to its mean. In the context of mutual funds, it reflects the volatility or risk associated with the fund. A higher standard deviation indicates greater variability in returns, signifying higher risk.
Understanding standard deviation is crucial for investors, as it helps distinguish between volatile and stable assets. For instance, a growth fund might exhibit a higher standard deviation compared to an index fund, reflecting a more aggressive investment approach.
Beta is a metric used in fundamental analysis to assess the sensitivity of an asset or portfolio to market movements. A beta of 1 indicates that the asset moves in line with the market, while a beta greater than 1 suggests higher volatility and a beta less than 1 indicates lower volatility.
Investors use beta as a risk-reward measure, helping them determine the trade-off between risk and potential returns. A beta greater than 1 implies higher risk and return potential, while a beta less than 1 indicates lower risk and potentially lower returns.
Beta: Covariance / Variance
Where Covariance is a measure of a stock’s return relative to the market and Variance measures how the market moves relative to its mean.
Let’s assume an investor, Rohan, wants to calculate the beta of Stock X as compared to the Index XYZ. Based on data over the past 10 years, Stock X and Index XYZ have a covariance of 0.044, and the variance of Index XYZ is 0.026. Beta of X =0.044/0.026 = 1.69
In this case, Stock X is considered more volatile than the market as its beta of 1.69 indicates that the stock experiences 69% more volatility than Index XYZ.
Correlation measures the degree to which two assets move in relation to each other. The correlation coefficient, ranging from -1 to +1, signifies the strength and direction of the relationship. A perfect positive correlation (1) indicates movements in the same direction, while a perfect negative correlation (-1) signifies opposite movements. For example, Large-cap mutual funds generally have a high positive correlation to the NIFTY.
Correlation is vital for portfolio management, as assets with low correlation offer effective diversification, helping to manage overall portfolio risk.
Beta correlation specifically evaluates a fund’s volatility compared to a benchmark. It provides insights into how a fund’s performance aligns with market movements. This metric aids investors in understanding how a fund’s performance might swing compared to a benchmark. A lower beta correlation indicates less volatility compared to the benchmark.
Consider an investor aiming to calculate the beta of Stock A concerning the Index ABC. Drawing on data from the past 10 years, the correlation between Stock A and Index ABC is determined to be 0.88. Further, Stock A exhibits a standard deviation of return of 25%, while Index ABC has a standard deviation of return of 36%.
Beta of Stock A = 0.88× (0.25/0.36) =0.611
In this case, Stock A is considered less volatile than the market as its beta of 0.611 indicates that the stock experiences 39% less volatility than the Index ABC.
Informed investing involves a comprehensive analysis of mutual fund ratios, considering factors such as average return, standard deviation, beta, and correlation. These metrics collectively provide a holistic view of a fund’s historical performance, risk profile, and relationship with the market. Armed with this knowledge, investors can make well-informed decisions aligned with their financial goals and risk tolerance.