Understanding Risk in Mutual Fund: Beta, Standard Deviation and R-square

India’s bellwether equity indices are touching their lifetime highs almost every week. And if analysts are to be believed, the party is likely to continue for a while with little hiccups in between. Such a run-up in the equity market has attracted a lot of investments in the mutual fund, especially in the ones dedicated to equities.

Most of the investors identify funds after looking at the fund’s historical return, without giving much thought on the level of risk they took to generate such return. Ideally, returns should always be considered in conjunction to risk. There are two measures of risk that are mostly used for mutual fund scheme one is beta and second is the standard deviation.

Beta measures a fund’s sensitivity compared to that of the benchmarks. It indicates, how the fund will perform when compared to its benchmark. So, if a fund is having a beta of 1.1, for every 20% upside or downside of benchmark will lead to 32% upside or downside of the fund, respectively. Hence, if an investor is a risk aversive and wants his investment to be stable, he will prefer funds having a beta of less than one. On the other hand, if you are an investor who wants to take a risk, you can go for funds having a beta of greater than one.

Nevertheless, beta should be always looked along with R-square, which measures relationship or correlation between, portfolio and benchmark. Beta uses the index to calculate relative movement. However, if the beta is calculated for large-cap fund against a mid-cap index, the resulting value will have no meaning. So, the fund will not move according to index. Therefore, R-square is used to understand how reliable the beta number is. Hence if the beta of a fund is high, however, its R-square is low, we cannot deduce much about the fund’s movement in line with its beta. R-square basically measures the effectiveness of beta and therefore both should always be assessed together.

Next measure of risk, normally considered in mutual fund investment is the standard deviation. While beta measures risk compared to the benchmark, the standard deviation is a statistical tool that measures the deviation of fund’s return compared to its own average return. It tells us how much a fund’s performance can deviate from its historical average returns both upwards and downwards.

Therefore, if a fund has generated an average return of 15 per cent and has a standard deviation of 5 per cent, the future returns are expected to be in the range of 10 to 20 per cent. Hence, an investor looking for a lower risk will look for funds that have lower standard variation.

Therefore, when you select a fund, besides historical returns you should assess these risk measures to put returns in right perspective.