Alpha

Alpha is a measure of an investment's performance on a risk-adjusted basis. It takes the

volatility (price risk) of a security or fund portfolio and compares its risk-adjusted
performance to a benchmark index. The excess return of the investment relative to the return
of the benchmark index is its "alpha."

Simply stated, alpha is often considered to represent the value that a portfolio manager adds
or subtracts from a fund portfolio's return. A positive alpha of 1.0 means the fund has
outperformed its benchmark index by 1%. Correspondingly, a similar negative alpha would
indicate an underperformance of 1%. For investors, the more positive an alpha is, the better it
is.

Beta
Beta, also known as the "beta coefficient," is a measure of the volatility, or systematic risk, of
a security or a portfolio in comparison to the market as a whole. Beta is calculated using
regression analysis, and you can think of it as the tendency of an investment's return to
respond to swings in the market. By definition, the market has a beta of 1.0. Individual
security and portfolio values are measured according to how they deviate from the market.

A beta of 1.0 indicates that the investment's price will move in lock-step with the market. A
beta of less than 1.0 indicates that the investment will be less volatile than the market, and,
correspondingly, a beta of more than 1.0 indicates that the investment's price will be more
volatile than the market. For example, if a fund portfolio's beta is 1.2, it's theoretically 20%
more volatile than the market.

Conservative investors looking to preserve capital should focus on securities and fund
portfolios with low betas, whereas those investors willing to take on more risk in search of
higher returns should look for high beta investments.

R-Squared
R-Squared is a statistical measure that represents the percentage of a fund portfolio's or
security's movements that can be explained by movements in a benchmark index. For fixed-
income securities and their corresponding mutual funds, the benchmark is the U.S. Treasury
Bill, and, likewise with equities and equity funds, the benchmark is the S&P 500 Index.

R-squared values range from 0 to 100. According to Morningstar, a mutual fund with an R-
squared value between 85 and 100 has a performance record that is closely correlated to the
index. A fund rated 70 or less would not perform like the index.

Mutual fund investors should avoid actively managed funds with high R-squared ratios,
which are generally criticized by analysts as being "closet" index funds. In these cases, why
pay the higher fees for so-called professional management when you can get the same or
better results from an index fund?

Standard Deviation
Standard deviation measures the dispersion of data from its mean. In plain English, the more
that data is spread apart, the higher the difference is from the norm. In finance, standard
deviation is applied to the annual rate of return of an investment to measure its volatility
(risk). A volatile stock would have a high standard deviation. With mutual funds, the standard
deviation tells us how much the return on a fund is deviating from the expected returns based
on its historical performance.

Sharpe Ratio
Developed by Nobel laureate economist William Sharpe, this ratio measures risk-adjusted
performance. It is calculated by subtracting the risk-free rate of return (U.S. Treasury Bond)
from the rate of return for an investment and dividing the result by the investment's standard
deviation of its return.

The Sharpe ratio tells investors whether an investment's returns are due to smart investment
decisions or the result of excess risk. This measurement is very useful because although one
portfolio or security can reap higher returns than its peers, it is only a good investment if
those higher returns do not come with too much additional risk. The greater an investment's
Sharpe ratio, the better its risk-adjusted performance.

The Bottom Line

Many investors tend to focus exclusively on investment return, with little concern for
investment risk. The five risk measures we have just discussed can provide some balance to
the risk-return equation. The good news for investors is that these indicators are calculated
for them and are available on several financial websites, as well as being incorporated into
many investment research reports. As useful as these measurements are, keep in mind that
when considering a stock, bond or mutual fund investment, volatility risk is just one of the
factors you should be considering that can affect the quality of an investment.

Read more: 5 Ways To Measure Mutual Fund Risk

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Every investor has a tendency to focus only on returns. However, it is very important to also
consider the risk aspect of the investment since risk and return are two sides of the same coin.

For a mutual fund, it becomes more difficult when it entails investment in equity instruments
in general. There are number of ratios which mutual fund investors should consider before
making their investments. We attempt to demystify some of the popular ratios used in this
regard. This is not a foolproof tool but can be used in conjunction with other analysis as well.
Among the most commonly used ratios to measure risk, there are 3 ratios; we come across
these very often but fail to understand their importance. These are:

1. Standard Deviation 2. Beta 3. Sharpe ratio

1. Standard Deviation (SD):

• It tells how much the return of a particular fund is deviating from the expected returns based
on its historical performance. In other words, it can be said that it evaluates the volatility of
the fund.
• The standard deviation of a fund measures this risk by measuring the degree to which the
fund fluctuates in relation to its average return of a fund over a period of time.
• High standard deviation denotes high volatility. For example : a fund with standard
deviation of 10% will have a tendency to deviate 10% from its average return.

Let us look at an example,

Fund Name 1-yr Returns (%) SD (%)

Fund A- UTI Top 100 Fund 19 18
Fund B- Reliance Top 200 Fund 19 20

Source: ACE MF, Data as on 27th March 2014

In the above case both are equity diversified large cap funds, we can see that both have
similar returns but fund B's SD is 20 which is more risky or volatile than fund A. In such
cases, one should prefer fund A since its returns are comparable to fund B and are more
predictable.

2. Beta:
• It is a measure of volatility or systematic risk of a security or a portfolio compared to the
market as whole. A fund with a beta greater than 1 is considered more volatile than the
market; less than 1 is less volatile. Funds with higher beta signifies greater volatility and are
considered to carry a higher risk.
• If Beta is more than 1: It means fund moves up / down with the market with greater
proportionate. E.g. if market goes up by 10%, then fund with beta 1.2 will move up by 12%
and vice versa.

However, whether a high beta is good or bad depends upon the state of the market. If the
market sentiments are bullish, then a high beta stock is better and if the market sentiments are
bearish then, low beta stock is better.

3. Sharpe ratio:
• This is one of the most widely used performance tracker in the mutual fund industry. It
evaluates the return that a fund has generated relative to the risk taken. It shows whether the
returns from investments are due to smart investment decisions or the result of excess risk
taken by the Fund Manager.
• Sharpe Ratio depicts what is the return earned at what level of risk.

Fund Name Beta SD Sharpe 1-yr Returns (%)

HDFC Capital builder Fund 18 24
Reliance Vision Fund 21 24

Source: ACE MF, Data as on 27th March 2014

• In the above example, both funds have given absolute return of 24% each in last one year
period. Reliance's fund with an SD of 21 was more volatile than HDFC's (SD of 18). This
implies that HDFC’s fund carried less risk compared to Reliance.
• Which fund is better among the two, given the situation?
• Obviously, HDFC Capital Builder Fund is better, as it is offering same return at a lower risk
(represented by standard deviation)
• Higher ratio depicts a high return with lower risk. (Here, Sharpe ratio of HDFC's fund is
higher than Reliance's Fund).

Let us consider another example, where risk measures - Beta and Std. Dev are same and
returns generated by them are different for the same period.

Fund Name Beta SD Sharpe 1-yr Returns (%)

Principal Large Cap Fund 0.91 20 0.07 22
Franklin India Bluechip Fund 0.91 20 0.05 15

• From the above table, we can see that if the investor was faced with the same levels of risk,
he should have gone for Principal large cap fund which gave 22% returns, whereas Franklin
India Bluechip fund posted only 15% returns for the same tenure. Thus, if one has to choose
between two funds with the same level of risk, then he should go for a fund which generated
higher returns.
• The above interpretation is only for analytical purposes; both the funds have similar
characteristics and belong to the same category.

In a nutshell,

Ratio Name Significance

Standard The lower this figure, the better the fund is, as a higher figure means more
Deviation inconsistency and a higher risk of a downslide in return.
Gives an idea of how much a fund is likely to move compared to movements of
Beta the benchmark. Thus, if you are Bullish; you should opt for a high beta funds
and go in for a low beta if you are bearish.
Sharpe Funds that post a higher-than-market Sharpe are preferable. And a ratio that
 does not beat the risk free rate of return is worth ignoring.

 Alpha

It considers the volatility of a fund portfolio and then compares it with a benchmark index.
The additional investment return relative to the return of the benchmark index is called its
‘alpha’. A positive alpha indicates that the fund has outperformed its benchmark index by 1
% and a negative alpha shows the fund’s underperformance of 1%. The investment is better
when alpha is more positive.

 Beta

This risk indicator shows a mutual fund’s volatility in comparison to the market as a whole.
In simple words, investors think of beta as the tendency of an investment’s return to respond
to swings in the market. It is calculated using regression analysis. If a fund has a beta greater
than 1, then the fund is more volatile than the market and vice versa.

 R-Squared

It is a statistical measure that shows the percentage of a portfolio’s movement from its
benchmark index movements. Generally, the value of R-squared ranges from 0 to 1. If a
mutual fund has an R-squared value between 0.85 to 1 shows a performance record that
closely correlated to the index and vice versa. It is advisable to prefer actively managed funds
with low R-squared ratios.

 Standard deviation

It is applied to the annual rate of return of an investment to calculate its volatility. This gives
mutual fund investors an idea about how much the return on a fund is deviating from the
expected returns based on its historical performance.

 Sharpe ratio

This ratio measures risk-adjusted performance and it helps investors understand that whether
an investment’s return is because of excessive risk factor or smart investment decision. When
an investment’s sharpe ratio is high, its risk-adjusted performance is also better.
Alpha
Alpha gives a measure of the risk adjusted performance of your investment. Simply put, it
will give you an idea of the excess returns that your invested fund may generate, compared to
its benchmark. For example, if a mutual fund scheme has an alpha of 5.0, it usually means
that the fund has outperformed its benchmark index by 5%. It can be seen as the additional
value the mutual fund manager adds or takes away from the return on your portfolio. Alpha
can be negative or positive.
Let’s say you invest in a mutual fund XYZ, having BSE Sensex as its benchmark. Let’s
further assume that BSE Sensex that has given a return of 20% in a specific year. If the given
value of alpha is positive 2.0, then it means that XYZ has outperformed its benchmark index
by 2% and given 22% as returns for that specific year. Similarly, a negative alpha of 2.0 may
mean that XYZ has underperformed compared to BSE Sensex and given 18% as returns for
the specific year.
Beta
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.
For example, if your mutual fund portfolio XYZ has a beta of 0.70, it denotes lower
volatility. This means that for every rise or fall of 1 in the market, the value of XYZ may rise
or fall by 0.70. If you have a low to medium risk profile, then you should look at funds
having a lower beta value. Further, when looking at beta, it always preferable to also check
how closely your mutual fund portfolio mirrors the benchmark.This correlation can also be
seen by a ratio called R-Squared. R2 or R-Squared is a statistical measure that explains to
what extent the portfolio movement mirrors the movement by the benchmark index. The
values of R-Squared lie between 0-100. The value of R-Squared needs to be higher than 80 to
indicate a high correlation of beta and the mutual fund portfolio. Beta may not be so effective
in case your portfolio doesn’t closely follow the benchmark.
Standard Deviation
Standard deviation is a statistical tool that measures the deviation or dispersion of the data
from the mean or average. When seen in mutual funds, it tells you how much the return from
your mutual fund portfolio is straying from the expected return, based on the fund’s historical
performance. For example if the portfolio XYZ has a standard deviation of 7% and average
return of 15%, it means that it has a tendency of deviating by 7% from its expected average
return and may give returns between 8% to 22%. Standard deviation is directly proportional
to the volatility of the portfolio. It is also used in calculating Sharpe’s Ratio.
Sharpe’s Ratio
The Sharpe’s ratio uses standard deviation to measure a mutual fund’s risk adjusted returns. It
will tell you how well your mutual fund portfolio has performed in excess of the risk-free
return (if you would have invested in government securities instead, which are almost risk-
free). This essentially gives you an idea if your returns are due to smart investment decisions
or excessive risk. Higher the Sharpe’s ratio, better the risk adjusted return of your mutual
fund portfolio.
You can combine the inferences from the above methods of measuring risk with information
like the fund history, past performance and expense ratio to identify the best-suited mutual
fund schemes for your portfolio and your risk profile.