How to measure performance of mutual fund schemes

Performance evaluation of mutual fund has been under scrutiny for while now. Earlier it was Sharpe ratio that ruled the performance metric. Still widely used, but some more metrics have appeared that measure the risk-adjusted performance of mutual funds. Understanding these ratios and using them to gauge the performance of mutual fund scheme will help you to select a fund that fits your risk profile.

Before delving deep into latest in the field of mutual fund performance, we should know two of the most commonly used measures of risk used in the finance industry; variance and standard variation. The variance of return is calculated by taking the average squared difference between individual returns and its mean value. While standard variation is the square root of the variance. They both are being measured in percentage term and shows how the returns vary from mean return on both sides that are negative as well as positive. Standard deviation is also referred as risk.

Risk Measure

There are three traditional performance measures (Sharpe ratio, Treynor ratio and information ratio) and three downside risk measures (Adjusted Sharpe ratio and Sortino ratio) primarily used to compare funds. Let us discuss one by one

Sharpe ratio measures fund’s excess returns over risk-free rate for per unit of the standard deviation of the portfolio’s returns. Therefore, larger the Sharpe ratio better is the risk-adjusted performance of the fund. However, it can be misleading in the case where the excess returns of a fund is compared to risk-free rate is negative. For example, if there are two funds with similar negative excess returns of -10 per cent and different volatility of say 10   per cent and 20 per cent. The fund with higher volatility has larger Sharpe ratio, which is not correct as both are generating similar returns.

Information ratio measures how well a portfolio has performed against its benchmark. It divides fund’s excess return over its benchmark by the standard deviation of excess returns over the benchmark. Again, larger the ratio better it is. It also reflects fund manager’s ability to beat its benchmark.

Treynor ratio uses beta as risk measure instead of standard deviation that has been used in the earlier measure of risk or risk-adjusted returns. Beta, however, is not a risk parameter and is actually fund’s returns correlation to benchmark. Higher the ratio better the performance of the fund.

In adjusted Sharpe ratio, the average of excess returns is divided by the measure of dispersion corresponding to the standard deviation of the excess returns. The advantage over traditional Sharpe ratio is that adjusted Sharpe ratio takes funds excess returns’ skewness and kurtosis into account when these returns don’t display a normal distribution pattern. Any distribution is said to be normal if data points are equally distributed on both sides of the mean of the data. Many study have shown that asset returns are not normally distributed.

Sortino Ratio is one of the most widely used ratios to check downside risk of the fund. It is also in a way deviation to Sharpe ratio, however, in denominator it uses only downside deviation. It penalises only those returns falling below a target rate of return, unlike Sharp ratio that penalises both upside and downside volatility.

The performance measures ratios mentioned above can be used to sort the funds. Despite all the recent advancement in calculating different performance measures, some of the studies in the international market show traditional measures using standard variation still predicts consistency in performance.