MF terminology - Is it all greek?
Srujani Panda / 06 Dec 2011
Under normal conditions, a rational investor avoids taking unnecessary risks. However, risk is one of the subjects where there is widespread agreement on the surface, but little agreement on the details. The situation is further complicated by the use of Greek terms like ‘alpha’ and ‘beta’. Speaking of risk in the context of mutual funds, there are fundamentally five ways in which risk is measured. These are alpha, beta, R-square, standard deviation and the Sharpe Ratio. All these give us a historical perspective of the risk associated with an MF scheme portfolio. Here is what to look for when you want to analyse the risk profile of fund schemes.
Standard deviation remains the most traditional and popular measure of risk. Harry Markowitz, a US economist credited with devising the modern portfolio theory in 1952, used it for the first time to demonstrate the trade-off between risk and return. Standard deviation, in pure mathematical terms, measures the dispersion of data from its mean. In finance, it shows how the returns of an investment are scattered around its average returns. Higher the standard deviation, greater is the risk factor associated with the investment. What this means is that when a portfolio has a high standard deviation, the predicted range of performance is wide, implying greater volatility.
Therefore, investors should pick schemes that have a lower standard deviation. For the 278 mutual fund schemes that we studied, the average annual standard deviation is 25.9. Two funds that have shown minimum volatility in their returns are Birla Sun Life International Equity Plan and DWS Global Thematic Offshore Fund, which have an annual volatility of 13.4 and 14.71 respectively.
The next measure of the riskiness of a portfolio is its ‘beta’. This measures the fund’s sensitivity to the market movements, or in simple words, the percentage change in the NAV of the funds for every one per cent change in the broader market as represented by an index. For example, the HSBC Equity Fund has a beta of 0.75, which means that it tends to move 0.75 times in the direction that the market moves. Hence, if the market moves up (down) by 10 per cent, HSBC Equity will move up (down) by 7.5 per cent. The beta can be seen as the tendency of the scheme’s returns to swing with or against the broader market. Therefore, a fund with beta of one will imitate the market exactly, and a fund with a beta of more than one will rise or fall more than the market, as the market moves up or down respectively.
A higher beta is definitely good in a rising market or during a bullish period, as it will move higher than the market. A lower beta is considered good during a bearish market. However, it is not easy to gauge the market movement and switch your investments accordingly. Hence, for an aggressive investor, a fund scheme with a higher beta will be more appropriate. On the other hand, funds with portfolios that have a lower beta are suitable for investors who are more concerned with capital protection.
Some funds with a low beta are Birla SunLife International Equity Plan A and DWS Global Thematic Offshore Fund, with beta values of 0.29 and 0.3 respectively. Schemes with a higher beta are mostly Mid-Cap and infrastructure funds like Magnum Midcap and Taurus Infrastructure, with beta values of 1.32 and 1.41 respectively.
The beta has to be interpreted along with the ‘R-square’, also known as the coefficient of determination. This is a correlation coefficient, and explains the percentage of movement in the fund’s returns that can be explained by the movement in a benchmark index. What this essentially means is that if a fund has an R-square of 0.5, then 50 per cent of the fund’s returns are explained by the index returns and the rest by other factors. Therefore, it becomes important to use such indices for the calculation of beta values that have a strong correlation with the funds. Otherwise, it may show results that are not reliable.
For example, if an individual had put money into a banking fund that invests primarily in banking stocks, it will usually have a low beta, as its performance is tied more closely to the performance of the banking stocks than to the overall stock market. Thus, the specialty fund might fluctuate wildly because of rapid changes in the share prices of the banking stocks, but its beta will remain low. The R-squared general correlation to the overall stock market would be lower than that of the funds, but the volatility would still be high. Therefore, a higher R-square value would indicate more useful beta. For our sample of 278 funds, the median R-square works out to 0.91, which means that the beta is reliable for most of the funds.
As yet, we have looked at factors that are used to determine the riskiness of funds. There are some more Greek terms that are used to measure the returns of your funds.
Let’s start with ‘alpha’, which is used to determine the excess risk adjusted (for beta) returns of the investment relative to its benchmark index. A positive (negative) alpha indicates whether the fund has performed better (worse) than what its beta would predict. Therefore, a positive alpha of 1.0 means that the fund has outperformed its benchmark index by 1 per cent. Correspondingly, a negative alpha would indicate an underperformance of 1 per cent. The higher the alpha, the better it is for an investor. In our study, we found that out of 278 schemes, 152 had an alpha of more than one. The best alpha of 23.91 was generated by DSPBR World Gold, followed by Birla SunLife MNC and Magnum FMCG with alpha values of 17.05 and 16.97 respectively. However, 93 funds have yielded a negative alpha.
Another measure of performance is the Sharpe Ratio. This was developed by Nobel Laureate William Sharpe to measure risk-adjusted returns. It is calculated by deducting the risk-free returns from the portfolio returns, and dividing the result by the standard deviation of the portfolio returns. The ratio basically tells us whether an investment’s returns are due to excessive risk taken by a fund manager or due to the right choice of stocks. Therefore, the higher the Sharpe Ratio, the better the fund’s historical risk-adjusted performance. The median Sharpe Ratio for 278 funds that we studied is 0.78, and the highest is 2.12.
Now that we have explained what all these volatility measures mean, the next time that you select funds to invest in, you should carefully assess the risk of the funds. Look for funds that are less volatile and give you a maximum return for a given level of riskiness. Remember, this is even more important in the current volatile conditions
Standard deviation remains the most traditional and popular measure of risk. Harry Markowitz, a US economist credited with devising the modern portfolio theory in 1952, used it for the first time to demonstrate the trade-off between risk and return. Standard deviation, in pure mathematical terms, measures the dispersion of data from its mean. In finance, it shows how the returns of an investment are scattered around its average returns. Higher the standard deviation, greater is the risk factor associated with the investment. What this means is that when a portfolio has a high standard deviation, the predicted range of performance is wide, implying greater volatility.
Therefore, investors should pick schemes that have a lower standard deviation. For the 278 mutual fund schemes that we studied, the average annual standard deviation is 25.9. Two funds that have shown minimum volatility in their returns are Birla Sun Life International Equity Plan and DWS Global Thematic Offshore Fund, which have an annual volatility of 13.4 and 14.71 respectively.
The next measure of the riskiness of a portfolio is its ‘beta’. This measures the fund’s sensitivity to the market movements, or in simple words, the percentage change in the NAV of the funds for every one per cent change in the broader market as represented by an index. For example, the HSBC Equity Fund has a beta of 0.75, which means that it tends to move 0.75 times in the direction that the market moves. Hence, if the market moves up (down) by 10 per cent, HSBC Equity will move up (down) by 7.5 per cent. The beta can be seen as the tendency of the scheme’s returns to swing with or against the broader market. Therefore, a fund with beta of one will imitate the market exactly, and a fund with a beta of more than one will rise or fall more than the market, as the market moves up or down respectively.
A higher beta is definitely good in a rising market or during a bullish period, as it will move higher than the market. A lower beta is considered good during a bearish market. However, it is not easy to gauge the market movement and switch your investments accordingly. Hence, for an aggressive investor, a fund scheme with a higher beta will be more appropriate. On the other hand, funds with portfolios that have a lower beta are suitable for investors who are more concerned with capital protection.
Some funds with a low beta are Birla SunLife International Equity Plan A and DWS Global Thematic Offshore Fund, with beta values of 0.29 and 0.3 respectively. Schemes with a higher beta are mostly Mid-Cap and infrastructure funds like Magnum Midcap and Taurus Infrastructure, with beta values of 1.32 and 1.41 respectively.
The beta has to be interpreted along with the ‘R-square’, also known as the coefficient of determination. This is a correlation coefficient, and explains the percentage of movement in the fund’s returns that can be explained by the movement in a benchmark index. What this essentially means is that if a fund has an R-square of 0.5, then 50 per cent of the fund’s returns are explained by the index returns and the rest by other factors. Therefore, it becomes important to use such indices for the calculation of beta values that have a strong correlation with the funds. Otherwise, it may show results that are not reliable.
For example, if an individual had put money into a banking fund that invests primarily in banking stocks, it will usually have a low beta, as its performance is tied more closely to the performance of the banking stocks than to the overall stock market. Thus, the specialty fund might fluctuate wildly because of rapid changes in the share prices of the banking stocks, but its beta will remain low. The R-squared general correlation to the overall stock market would be lower than that of the funds, but the volatility would still be high. Therefore, a higher R-square value would indicate more useful beta. For our sample of 278 funds, the median R-square works out to 0.91, which means that the beta is reliable for most of the funds.
As yet, we have looked at factors that are used to determine the riskiness of funds. There are some more Greek terms that are used to measure the returns of your funds.
Let’s start with ‘alpha’, which is used to determine the excess risk adjusted (for beta) returns of the investment relative to its benchmark index. A positive (negative) alpha indicates whether the fund has performed better (worse) than what its beta would predict. Therefore, a positive alpha of 1.0 means that the fund has outperformed its benchmark index by 1 per cent. Correspondingly, a negative alpha would indicate an underperformance of 1 per cent. The higher the alpha, the better it is for an investor. In our study, we found that out of 278 schemes, 152 had an alpha of more than one. The best alpha of 23.91 was generated by DSPBR World Gold, followed by Birla SunLife MNC and Magnum FMCG with alpha values of 17.05 and 16.97 respectively. However, 93 funds have yielded a negative alpha.
Another measure of performance is the Sharpe Ratio. This was developed by Nobel Laureate William Sharpe to measure risk-adjusted returns. It is calculated by deducting the risk-free returns from the portfolio returns, and dividing the result by the standard deviation of the portfolio returns. The ratio basically tells us whether an investment’s returns are due to excessive risk taken by a fund manager or due to the right choice of stocks. Therefore, the higher the Sharpe Ratio, the better the fund’s historical risk-adjusted performance. The median Sharpe Ratio for 278 funds that we studied is 0.78, and the highest is 2.12.
Now that we have explained what all these volatility measures mean, the next time that you select funds to invest in, you should carefully assess the risk of the funds. Look for funds that are less volatile and give you a maximum return for a given level of riskiness. Remember, this is even more important in the current volatile conditions
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