Know how to select mutual funds like a Pro

While you may be comfortable pouring over hundreds of reports before making a presentation in your office, you somewhat hesitate going through the factsheets or digging up the key numbers related to the funds you have invested in.     

If you can relate to this, then these ratios will help you understand the nuts and bolts of your fund. Here is a summary of major financial ratios and what they mean.

Alpha: The alpha that we are going to talk about is not the first letter of the Greek language, but it is the definitely the first ratio you need to know about mutual funds. Alpha is the measure of fund’s performance on a risk-adjusted basis as compared to its benchmark. Higher the Alpha, better the fund!

Standard Deviation: Another important ratio that you should check is Standard Deviation. As the word suggests, standard deviation shows how much the fund can deviate from its historical average returns. Thus, higher the standard deviation, more volatile is the fund’s return. For example, if a fund has a 12% average rate of return and a standard deviation of 4%, its return may range from 8-16%. Lower the standard deviation, better the fund.

Sharpe ratio: The lure of higher returns is one of the main reasons why you invest in riskier products such as equities and equity mutual funds. But can you measure if the risk that you are taking is worth it? Yes, why not? Sharpe ratio shows how much excess returns you are gaining from holding a riskier asset. Simply, Sharpe ratio helps you evaluate risk-adjusted returns of a fund. You can compare the Sharpe ratio of schemes within the same category. Higher the Sharpe ratio, better the fund.

Sortino ratio: The Sortino ratio is a level above Sharpe ratio. It differentiates harmful volatility from overall volatility. Simply, Sortino ratio shows how successfully a scheme’s fund manager was able to restrict the downside volatility of a scheme. A higher Sortino ratio indicates that the investment is earning more return for every unit of bad risk taken. Higher the Sortino ratio, better the fund.

Beta: While going through the fund sheet, you must have seen a small box on qualitative aspects. Beta is the first qualitative aspect. Beta measures a fund’s volatility compared to its underlying benchmark. It shows you how your fund would swing during the different market cycles vis-à-vis the benchmark. A beta is represented as less, more or equal to one. The beta exceeds one if the stock price movement surpasses market movement and less than one when the stock price moves less in comparison to the market. Lower the beta, better the fund.

Information ratio: While alpha is the outperformance of the fund as compared to its benchmark, Information ratio looks at the return generated for per unit of risk taken. Simply, this ratio is the returns the fund manager generated by deviating from the benchmark. Information ratio shows the fund manager’s ability to consistently generate active returns. Higher the information ratio, better the fund.

Treynor ratio: The Treynor ratio is a risk-adjusted return based on systematic risk, i.e. market risk or beta. This ratio takes into account the market risk because diversification will not remove the inherent risk associated with the market. It is similar to Sharpe ratio. The difference between the two ratios is that the Treynor ratio uses beta, or market risk, to measure volatility while Sharpe ratio takes the total risk (standard deviation). Higher the Treynor ratio, better the fund.

 Portfolio Turnover: As a name suggests, Port folio Turnover Ratio determines the churn of the fund portfolio, i.e. the extent to which a mutual fund turns over its stocks over a given time period.

If a fund has a low turnover, it indicates that the fund follows a buy and hold strategy. The fund manager has high conviction in his picks and hopes that it will give handsome returns. On the other hand, a high portfolio turnover means that the fund is going through frequent changes and this churning will convert into high transaction costs, which impacts the return for the investor. Lower the portfolio turnover, better the fund.

This was not as complicated as you must have thought, right?

With these ratios, you can now easily select a right fund for yourself! However, one should not evaluate a fund in a silo and need to consider various other parameters before taking a final decision.

Understanding these ratios will make it easier for you to know the story behind a mutual fund. However, it is advisable that you talk to your financial advisor before you take any decision.