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Evaluating Risk and Returns in Mutual Funds

Updated: Oct 10, 2023

Table of Content:

  • Introduction

  • Key Indicators of Investment Risk

  • Importance of Benchmarking

  • Mutual Fund Returns: Absolute and Annualised

  • Active vs. Passive Fund Management

  • Understanding Alpha and Beta in Depth

  • The Role of Standard Deviation

  • Importance of Periodic Reviews in Mutual Fund Investments

  • Frequency of Reviews

  • Act on Underperformance

Introduction:

Risk and Returns in Mutual Funds

Investing in mutual funds can be a way to make more money with your savings, but it's essential to know that risk and returns in Mutual Funds are involved. These risks are like the ups and downs of a roller coaster ride. To make intelligent decisions, you need to understand these risks and the rewards that come with them.


Think of it like driving a car. Before you hit the road, you want to know the traffic rules and the car's condition. In mutual funds, you want to know the rules of investing and how the fund has been performing.


A comprehensive understanding of these factors can aid investors in making informed decisions, thereby maximising their profitability and minimising potential losses. This article aims to provide an in-depth understanding of the key indicators of investment risk, the concept of risk-adjusted returns, and the importance of periodically reviewing mutual fund performance.

Risk and Returns in Mutual Funds Factors in India

1. Key Indicators of Investment Risk

In the world of mutual funds, five primary risk indicators are commonly used to analyse stocks, bonds, and mutual fund portfolios.


Alpha: Measures a fund's excess return compared to its benchmark, indicating the manager's skill in generating returns beyond what the market provides.

Beta: Indicates the sensitivity of a fund's returns to market movements, showing how much it tends to move in relation to the overall market.

R-squared: Evaluates how closely a fund's performance matches its benchmark, reflecting how much the market explains its movements.

Standard Deviation: Measures the historical volatility or variability of a fund's returns, providing insights into its potential price swings.

Sharpe Ratio: Assesses a fund's risk-adjusted return, considering its returns and the level of risk taken to achieve them.


These five risk indicators help assess how risky mutual funds and investments are. They're like tools that experts use to predict how your money might go up and down.

2. Importance of Benchmarking

Benchmarking is a critical aspect of evaluating mutual fund performance. It involves comparing a fund's performance against a benchmark index such as the NIFTY 50 and BSE SENSEX. These comparisons help determine a fund's performance relative to these indices and provide insight into the risk-reward parameters of their investments.


3. Mutual Fund Returns: Absolute and Annualised

When calculating returns from mutual fund investments, two popular methods are used: absolute returns and annualised returns. While absolute returns reflect the simple increase or decrease in your investment as a percentage, annualised returns or Compound Annual Growth Rate (CAGR) measures the rate of return over an investment period, providing a smoothed rate of growth on an annually compounded basis.


4. Active vs. Passive Fund Management

Aspect

Actively Managed Funds

Passively Managed Funds (Index Funds)

Management Approach

​Actively managed by a fund manager

Passively managed, tracking an index

Stock Selection

Actively buys and sells stocks based on research and analysis

Mirrors the holdings and weightings of an index

Goal

Beat the market and generate higher returns

Match the performance of a specific index

Expense Ratio

Typically higher expense ratios due to active management

Generally lower expense ratios due to minimal trading

​Turnover Rate

Higher turnover rate as stocks are frequently bought and sold

Lower turnover rate as portfolio changes less frequently

Risk

Potentially higher risk due to active stock selection

Lower risk as it mirrors the broader market

Investor Involvement

Less hands-on for investors, as the fund manager makes decisions

More hands-off for investors, as it follows an index

Performance Consistency

Performance may vary widely based on the fund manager's skill and strategy

Performance closely tracks the index with minimal deviations


5. Understanding Alpha and Beta in Depth

Alpha and Beta are critical measures in the evaluation of mutual funds. Alpha measures the fund manager's contribution to the fund's performance, representing the fund's excess return over its predicted return based on its Beta. On the other hand, Beta measures the volatility of a security relative to a benchmark index, offering insights into the risk associated with the investment.

6. The Role of Standard Deviation

Standard deviation is a crucial measure of uncertainty in mutual fund investment. It measures how much a fund's return deviates from its mean return, thereby providing insights into the volatility and associated risk of the investment.

7. Importance of Periodic Reviews in Mutual Fund Investments

Periodic reviews of mutual fund performance are crucial in effective investment management. These reviews provide valuable insights into the fund's performance over time and can help investors identify underperforming funds and make informed decisions about future investments.


8. Frequency of Reviews

Although reviewing a fund's performance each time the market fluctuates significantly can be tempting, it's essential to resist this temptation. For an actively managed equity scheme, a reasonable time frame of between 18 and 24 months should be allowed for the fund to generate returns in the portfolio.

9. Act on Underperformance

It's advisable for investors to create a separate watch list of funds underperforming their benchmark or comparable peers. If a fund underperforms consistently over 3-4 quarters, consider shifting the investment to other, better-performing options.

10. Make Informed, Not Impulsive, Decisions

Frequent review and tracking of mutual fund returns may tempt investors into making impulsive decisions. It's essential to avoid letting a fall in NAVs tempt you into discontinuing SIPs or redeeming units from a fund. Instead, make informed decisions based on thorough analysis and review.

In conclusion, understanding the risks and potential returns associated with mutual fund investments is crucial for successful investing. By utilising platforms like AssetPlus, independent mutual fund distributors can tap into a wealth of tools and resources designed to educate and empower them. These resources are instrumental in building their brand and enhancing their business acumen. Remembering that successful investing hinges on making well-informed decisions, regularly reviewing your strategies, and gaining a profound understanding of the investment landscape is essential. For more information related to Risk and Returns in Mutual Funds investment in India just Call @ +91 95009 99110

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