Generally, when we are selecting mutual fund for long-term investment, we evaluate the performance of the funds. Evaluation is done based on the past returns (compounded annual growth rate) delivered by the funds and the consistency of its performance. The degree of risk associated with the funds is considered separately while choosing the best mutual funds. Risk and return are considered separately while evaluating the performance of funds. But there is a concept to consider both risks and return together to evaluate the performance of funds, which is known as ‘risk-adjusted return’. You can make fund choices based on its risk-adjusted return.
What is the risk-adjusted return?
Risk-adjusted return is an indication that measures return generated by the investment after taking into consideration the degree of risk taken to earn those returns. Risk-adjusted return can be a useful measure to choose the best mutual for the long term. Comparison of two different funds can be done based on risk-adjusted return.
How is risk-adjusted return calculated or measured?
Risk-adjusted return is nothing but the excess return generated by the mutual fund for the amount of risk associated with it. Risk-adjusted return can be measured using various ratios mentioned below:
- Standard Deviation: In mutual funds, standard deviation indicates the deviation of the fund’s return from the expected rate of return based on the fund’s historic performance. The value of standard deviation measures how volatile the fund is. Higher the value high is the volatility.
- Beta: Beta values are the indication of a fund’s sensitivity to varying market conditions. Basically, it measures how a fund’s portfolio value can vary as per the market movement. Beta value is also a measure of volatility.
- Sharpe Ratio: Sharpe ratio is used for the evaluation of the risk-adjusted return of mutual funds. Sharpe ratio is calculated using the below formula:
Sharpe Ratio = (Fund’s average return – Risk-free rate of return) / Standard deviation of the fund’s return
You can compare the Sharpe ratio of two funds from the same category or you can compare the Sharpe ratio of the fund with that of the underlying benchmark to make the best mutual fund choice.
- Treynor’s Ratio: Treynor’s ratio is used for the evaluation of the risk-adjusted return of mutual funds. Treynor’s ratio is calculated using the below formula:
Treynor’s Ratio = (Return generated by the fund – Risk-free rate of return)/ Beta value of the fund
You can shortlist the best mutual funds out of the group of funds. Funds with a higher ratio are considered to be good.
- Jenson’s Alpha: Jenson’s Alpha is used for the evaluation of the risk-adjusted return of mutual funds. Basically, it measures the outperformance of the mutual fund. This is based on the capital asset pricing model (CAPM). Funds with higher ratios are considered to be the best mutual funds.
Let’s take an example to understand this. Tata Digital India Fund-Direct Plan-Growth has ranked as the number one best mutual fund on ETmoney. Let’s take a look at the risk-adjusted return of this fund compared with various category ratios.
|Ratios||Tata Digital India Fund||Category Average||Indication|
|Standard Deviation||18.69||14.49||High volatility|
|Sharpe Ratio||1.7||0.78||Better risk-adjusted return|
|Treynor’s Ratio||0.36||0.17||Better risk-adjusted return|
|Jension’s Alpha||5.19||3.18||Better risk-adjusted return|
When choosing the best mutual fund for long-term investment, it is important to consider both return and the degree of risk associated with it simultaneously. ETmoney platform can help you choose the best mutual fund with better risk-adjusted returns. Make an informed and rational choice of investment for your long-term goals.
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