Mutual funds are great all-round investment vehicles. As managed products, they come equipped with some amount of diversification built-in and can adapt its holdings as the economic environment changes. But even with these fail-safes, mutual funds aren’t risk-free.
Performance isn’t everything. If a fund manages to put up impressive numbers but takes on too much risk, those figures could easily plummet. Investors want a product that balances risk and returns in a way that doesn’t compromise the integrity of their portfolio.
In order to analyze mutual funds properly, risk ratios need to be examined to determine how volatile they are. Key indicators like alpha, beta, R2, and standard deviation can help investors find mutual funds that match their risk tolerance and let them know how safe they’re return predictions will be.
This measurement compares performance relative to the risk associated with a mutual fund’s holdings. It uses the fund’s stated benchmark index as a base and gauges the fund’s performance and risk relative to it. Whatever excess returns the fund produces is known as its alpha.
This tells investors how much better or worse the fund does relative to the index itself. It’s also a gauge of how good the management of the fund is. Alpha is read as a percentage so an alpha of 1 means the fund outperformed its benchmark by 1%.
Beta measures how much a fund’s performance is dictated by its underlying benchmark. In other words, it tells investors how correlated a fund’s performance is to its index. It’s also used as a volatility measurement.
If a fund has a beta of 1, that means its performance will perfectly match the performance of the benchmark index. More than 1 means the fund will move in a direction greater than the index – up or down. Anything less than 1 and the fund will mark a lesser movement than the index. Some funds may even have a negative beta which tells you its performance is inversely correlated with the index.
An offshoot of a fund’s beta, R2 measures what percentage of a fund’s portfolio is attributed to changes in an underlying benchmark. Values range from 0 to 100 with 100 meaning 100% of the fund’s holdings can be attributed by changes in the index. Practically speaking, funds with a ratio of 70 or less are considered to trade in a manner not associated with its index.
R2 also helps investors get a clearer understanding of a fund’s beta. The higher the R2, the more accurate a fund’s beta is likely to be.
Standard deviation for a mutual fund tells investors how much variance there is in the fund’s returns. It’s based off the fund’s annual returns, so it’s only useful in a long term sense. It helps investors analyze the consistency of returns. It’s based on a percentage so a standard deviation of 10 means that fund will generate plus or minus 10% from it’s long term average returns.
As most investors are aware, past performance doesn’t guarantee future results. Mutual funds can change over time and become something else entirely. In many cases, funds can be absorbed and combined with other funds changing their risk profile. Investors will want to keep an eye on changes as they develop and determine whether a fund still matches their personal investment profile or not.