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Guide to Mutual Funds

Risk Return and Performance of Funds

Risk and Return go hand in hand for any investment, and the main purpose of investing is to earn returns, right?

So, an obvious question for any discussion about mutual funds is how to measure returns.

Like any other financial product, the returns on mutual funds can be measured in various ways. 


Here, we have discussed some common ones.


Absolute Returns

The simplest way to calculate returns is to determine how much you invested and how much you got. This is an absolute return.


For example, on 1st April 2020, you invested ₹10,000 in a mutual fund scheme. On 31st March 2021, it was worth ₹ 14,000. Thus your absolute return is 40% [(₹ 4,000/10,000)/100]


CAGR

But then, things are not so simple in real life. You will not withdraw your funds exactly at the end of 1 year.

Hence, the Compound Average Growth Rate (CAGR) is an efficient way of measuring absolute returns. It measures the rate at which your investment is growing. 

So, let’s suppose you invested ₹10,000 on 1st April 2018. After 3 years, the value of your investment is ₹25,000. So the CAGR of your investment is:

Rolling returns, however, provide a better picture of a fund’s performance than CAGR. We will discuss this in detail in the upcoming chapter. 


Alpha

As we mentioned while discussing the benchmark, each mutual fund’s performance is measured vis-à-vis a benchmark. This is a great way to understand whether the scheme has performed well or not against a given standard. 

The ratio that measures a mutual fund’s performance against a benchmark is known as the alpha. Alpha reflects the return generated by a scheme. Ideally, the Alpha should be higher than the Sharpe Ratio since the Sharpe Ratio measures return vis-à-vis risk-free return of the market. 

When selecting a mutual fund, consider those that have consistently generated a positive alpha over time. 


Sharpe Ratio

Risk-adjusted return is the return that your portfolio generates for the risk taken during the given time. It is measured by the Sharpe Ratio, which we have discussed in detail in chapter 11 of this module. 


Treynor’s Ratio

This ratio measures how much excess return was generated for each unit of risk taken by the portfolio. By excess return, we mean the return earned over and above the risk-free environment. A higher Treynor’s Ratio means that the fund has generated better returns for the amount of risk taken for each unit. 


Let us now see the Alpha, Sharpe Ratio, and Treynor’s Ratio of some of the most popular bluechip mutual funds:

Data were taken on 30.09.2021



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