Know these ratios before investing in a mutual fund scheme

An increasing number of people are investing their earnings into mutual funds. Professional management by established fund managers make it easier for investors than holding individual shares or securities in one's investment portfolio. However, this does not mean that all mutual funds are the same. While some of them are reputed for their short-term performance, others deliver greater returns over a long period.

Knowledge about the working of mutual funds is rare in most cases, thus, leaving investors confused while selecting their choice of fund. While there are myriad factors like risk appetite, the nature of investments (SIPs or lump sum), investment tenure, etc., the most important consideration involved is the investors' understanding of the funds. However, the same is difficult without the investors gaining an in-depth understanding of certain elements like the various mutual fund ratios that help gauge the quality of the fund and its viability in the long run. Some of the ratios that mutual fund investors must know include:

Standard deviation: Evaluating the standard deviation helps gauge the volatility of the fund's returns with respect to the fund's average returns. CS Sudheer, founder & CEO, Indianmoney.com says, "It shows how a fund's return deviates from its average. A fund having 9% average return and a standard deviation of 3%, gives returns in the range of 6-12%. A high standard deviation means that the NAV of the mutual fund is volatile and the fund is risky."

It is not difficult to calculate the standard deviation of a mutual fund that one may be eyeing to invest in. Exemplifying the same, Sudheer says, "Assume returns of a mutual fund are 17%, 15%, 23%, 7%, 9% and 13% over six years. Then the average mutual funds' return can be calculated by

Average Return (x?) = (17% + 15% + 23% +7% +9% + 13%)

                                                  6

                             x? = 14%

Calculate variance (S2) = (17-14)2 + (15-14)2 + (23-14)2 + (7-14)2 + (9-14)2 + (13-14)2

= 166 / 5 = 33.2

Standard Deviation (S) = ?33.2 = 5.76. This means that the standard deviation of the mutual fund is 5.76."

Beta: The value of "Beta" helps assess the systematic risk of the mutual fund when compared to the overall stock market. Vineet Patawari, co-founder, stock analytic app StockEdge and financial market learning portal Elearnmarkets.com, says, "It is calculated as covariance between the return of the mutual fund and the return of the market as a whole (often represented by a market index like Nifty). If the beta of a fund is more than 1, then its returns are more volatile than the returns generated by Nifty. Hence, it can be more rewarding as well as riskier than the market."

Sharpe ratio: This element of any mutual fund must not be ignored as it helps investors assess the quantum of returns earned at the level of risk taken by the fund. Ashwin Patni, head products and alternatives, Axis Mutual Fund, says, "Sharpe ratio is a composite metric that incorporates both risk and returns delivered by a fund into a single measurement. Thus, it can give investors a different perspective from what they get purely by looking at returns on a standalone basis. It is calculated as the excess fund return delivered over the risk-free rate per unit of volatility or total risk. Thus, it represents the fund managers ability to generate returns over the risk-free rate (zero risk theoretically) for every additional unit of risk that they take. Risk is captured using the standard deviation of the portfolio. Higher the sharpe ratio, better the returns the fund manager has been able to earn for the risk they undertook."

R-Squared: This ratio helps determines the quality of the portfolio by analysing its association with its benchmark. Experts argue that one must choose a mutual fund that has an R-Squared value between 70 and 100 considering that the fund's performance record correlates closely with that of the index. Sundaram Mutual Fund officials say, "Running a regression between the fund's performance and the benchmark on excel would give the R-Squared value, which explains the percentage of return attributable to the market." Avoid mutual funds with R-Squared value in the range of 40-100 as this would indicate average portfolio returns while those rated 40 or less than that indicates poorly performing funds that do not corroborate with that of the index movement.

Inclusion of mutual funds in a financial portfolio helps as many of them earn good returns that beat the market inflation. However, a lot depends on how long you wish to stay invested in the fund. Staying invested for a long period helps though a lot depends on the diversity of your investment portfolio. Just like other monetary instruments, it is important to carry out detailed research of the mutual funds before choosing the one you want to pay for.