Guide to Mutual Funds
Beta and Sharpe Ratio - A Measure of Risk
Although we have discussed quite a number of risks associated with mutual funds, any discussion of risk will remain incomplete without discussing two very important concepts – Beta and Sharpe Ratio.
Let us understand what they are and how they are relevant to mutual funds:
One of the most common indicators of risk is Beta. Beta measures a stock’s volatility against the overall market. If a stock moves in a similar manner as the market then its beta will be 1.0. If it is more volatile than the market, then the beta will be more than 1.0 and if it is less volatile than the market then the beta will be less than 1.0.
So, how is Beta related to mutual funds? It works similarly to stocks, only that in mutual funds the comparison is done to the relative benchmark that the mutual fund follows rather than the overall market.
Hence, a mutual fund’s beta of more than 1.0 means that the scheme is more volatile than its benchmark and vice versa.
Let us see the beta of some popular mutual funds of different categories:
Data were taken as of 30.09.2021
How is Beta Useful for you?
It is very evident that the higher the beta ratio, the more is the risk in the fund. But let’s not forget that the return will be higher too.
So, does a high return always mean a higher beta?
Not really. Funds with a beta of less than 1.0 can also provide high returns if the fund manager is good and can deliver superior results.
In the table provided above, you can see that all the schemes have a beta of less than 1. Yet, they have delivered good returns in the last 3-years.
Sharpe Ratio is another important ratio that takes into account risk-adjusted return. Risk-adjusted return is the profit from an investment, taking into account the amount of risk to be taken to achieve it. Generally, to calculate the risk-adjusted return, a risk-free asset is taken into consideration, such as a fixed deposit or a government bond. The extra return (over and above the risk-free asset) is viewed in light of the extra risk taken to achieve it. In India, the interest on government of India bonds is taken as a risk-free return for calculating Sharpe Ratio.
A Higher Sharpe Ratio means that the fund can generate better returns for the risk that is being taken.
How is Sharpe Ratio useful for you?
Sharpe ratio comes in very handy to compare multiple funds in the same category.
Among the 2 large-cap funds detailed in the table above, the Sharpe Ratio of Canara Robeco Bluechip Equity Fund is 0.94 while that of BNP Paribas Large Cap Fund is 0.87. This means that Canara Robeco has provided better returns for a similar degree of risk taken for this category of funds.