Measuring Risk of Mutual Funds

 Measuring Risk of Mutual Funds

Risk measurement Tools

There are various risk measuring tools developed by statisticians to measure the risk adjusted return, drawdown and downside risk that help fund managers and investors to identify the funds and construct their portfolio which would minimize the risk. In the past the performance of funds was only measured with the help of rate of return. Markowitz (1952) & Tobin (1958) suggested Mean-Variance to measure volatility in terms of market variability of returns. Treynor (1965), Sharpe (1966) and Jensen (1968) make comparison between the risk adjusted returns of professionally managed portfolios to that of some standard benchmark. Cumby & Glen (1990) and Lahbitant (1995) analyzed that Mutual Funds are under performing to their benchmark. Murthi (1997) identified the problem in performance of traditional tools while constructing appropriate portfolio for investment. So, due to these problems Murthi (1997) introduced Data Envelopment Analysis (DEA) to measure the performance efficiently. In India, Chander (2000) found the Mutual funds outperform while Singh & Singla (2000) found that Mutual funds underperform to their benchmark. Gupta (2001) found that mutual funds are outperformed as well as underperform as compared to their standard benchmark. Galagedera & Silvapulle (2002) found that mutual funds were efficient in terms of returns in long term. Lin and Chen (2008) found the number of mutual funds generate higher return at a given level of risk in the year 2003 than 2001 and 2002. Soongswang & Sanohdontree (2011) found that mutual fund provides varied return.

Types of Risk

Investment in mutual funds carries risk of loss as the portfolio invested in can make a loss due to several different reasons. These reasons are the risks that mutual funds are associated with. They are: -

a)      Market Risk: - It is the risk that may result in losses for an investor due to the poor performance of the market. Many factors including natural disasters, inflation, recession, political unrest and fluctuation of market rates affect the market. This risk is also known as systematic risk. Diversification of a portfolio does not help to alleviate this risk.

b)      Concentration risk: - It is the risk of concentrating a huge part of one’s investment in one particular scheme. This can lead to huge profits if lucky and pronounced losses if unlucky. Concentrating investments heavily in one sector is also risky. Diversification of portfolio helps alleviate this risk.

c)      Interest Rate risk: - The interest rate in the market changes according to the credit available with lenders and the demand from borrowers. Increase or decrease in the interest rate might lead to change in the price of securities – impacting the investment portfolio of the mutual fund.

d)      Liquidity risk: - It is the risk of being unable to redeem an instrument without suffering a loss in its value. It may also occur when buyers or sellers cannot be found for investments. It may render you unable to redeem investments when you need them most. Some mutual funds have a lock-in-period which creates this risk. Careful selection of funds to invest in and diversification of portfolio can help alleviate this risk.

e)      Credit risk: - It is the risk that the issuer of the scheme will be unable to pay the interest promised. Usually, agencies which handle investments are rated by rating agencies on these criteria. So, a person will always see that a firm with a high rating will pay less and vice-versa. Debt funds often suffer from credit risk as the mutual fund managers might include poorly rated investments in the portfolio to increase return. Checking the credit ratings of the investment portfolio is a must before choosing a mutual fund scheme.

Risk Analysis of Mutual Funds

Mutual funds operate on various themes which exposes them to different kind of risks. Although they are professionally managed but element of risk still remains. These risks can be attributed to economic performance, diversification, sector growth and individual company performance. Prior to taking an investment decision, the investor should crosscheck funds’ performance with respect to various risk measures. In this article we will try to understand the parameters using which funds’ performance is measured and risk analysis is done. Investors must perform comparative analysis of these parameters before making an investment decision.

Standard Deviation as a measure of risk

From a statistics standpoint, the standard deviation of a dataset is a measure of the magnitude of deviations between the values of the observations contained in the dataset. From a financial standpoint, the standard deviation can help investors quantify how risky an investment is and determine their minimum required return on the investment.


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Ri – the return observed in one period (one observation in the data set)

Ravg – the arithmetic mean of the returns observed

n – the number of observations in the dataset

Sharpe Ratio

Sharpe Ratio of a mutual fund reveals its potential risk-adjusted returns. The risk-adjusted returns are the returns earned by an investment over the returns generated by any risk-free asset such as a fixed deposit. However, higher returns indicate extra risk. Higher Sharpe Ratio means greater returns from an investment but with a higher risk level. Therefore, it justifies the underlying volatility of the funds. The investors aiming for higher returns will have to invest in funds with higher risk factors.


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Beta denotes the sensitivity of the mutual fund towards market movements. It is the measure of the volatility of the mutual fund portfolio to the market. When you are looking at the beta of a mutual fund, you are finding out the tendency of your investment's return to respond to the ups and downs in the market. Here, the market usually refers to the benchmark index the fund follows. The beta of the market or benchmark is always taken as 1. Any beta less than 1 denotes lower volatility and higher than 1 denotes more volatility compared to the benchmark index.

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Covariance = Measure of a stock’s return relative to that of the market

Variance = Measure of how the market moves relative to its mean

Treynor Ratio

The Treynor ratio, also known as the reward-to-volatility ratio, is a performance metric for determining how much excess return was generated for each unit of risk taken on by a portfolio. Excess return in this sense refers to the return earned above the return that could have been earned in a risk-free investment. Although there is no true risk-free investment, treasury bills are often used to represent the risk-free return in the Treynor ratio. Risk in the Treynor ratio refers to systematic risk as measured by a portfolio's beta. Beta measures the tendency of a portfolio's return to change in response to changes in return for the overall market.

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