You might have noticed the mutual fund expense ratio when you are exploring the different funds, but do you know what it actually means? It is very important to analyze expense ratio and other mutual fund ratios to make the best investment decision. So, let’s delve into this and understand all the ratios in detail.
10 Key Mutual Fund Ratios
Every ratio tells something different about a mutual fund‘s performance or quality, helping you analyze the underlying risk and returns generated by the fund.
Mutual Fund Expense Ratio
The total expense ratio in mutual fund includes the cost incurred by the fund house in managing the scheme. The daily NAV of the fund is updated by the fund house after deducting the TER. If a fund has an AUM of ₹200 crores and it is spending ₹2 crores in managing it, then its expense ratio is 1%. This 1% is deducted from the daily NAV of the fund.
NAV is the cost of buying or selling one unit of a fund. So, if the mutual fund expense ratio is higher, then the NAV will be lower and so is your redemption value at the time of selling. Therefore, it is better to select a fund that has a lower expense ratio.
Sharpe Ratio in Mutual Fund
After understanding the mutual fund expense ratio, let’s understand what is Sharpe ratio in mutual fund. The risk-free rate of return (given by the government bonds) is subtracted from the fund’s return and then the resulting value is divided by the fund’s SD to get the Sharpe ratio.
The Sharpe ratio in mutual fund tells you about how the fund is generating returns, whether it is through excess risk or it is the fund manager who has made the wise decisions. So, if the fund’s Sharpe ratio is higher than its peers in the same category, then it is considered better because it has delivered better risk-adjusted returns. If the fund’s Sharpe ratio is negative, then the risk-free asset is a much better choice.
Suppose there are two equity mutual funds, where fund X has given 12% returns and fund Y has given 10% returns in the last 1 year. Through returns, you can see that fund X is better.
But the real story can be different. Now, consider the risk-free rate of return in the economy is 5%. The SD of fund X is 10% and the SD of fund Y is 3%.
Then, what is Sharpe ratio in mutual funds X and Y:
Sharpe ratio of X = (12 – 5) / 10 = 0.7
Sharpe ratio of Y = (10 – 5) / 3 = 1.667
The Sharpe ratio of Y is better than X, which means it has given better risk-adjusted returns.
Sortino Ratio in Mutual Fund
The Sortino ratio considers that all risk is not bad while the downside volatility is only something to take care of. So, the formula is similar to the Sharpe ratio in mutual fund with the only difference being that apart from total SD, it considers SD of negative returns.
A higher Sortino ratio in mutual fund is always better because it means there are fewer chances of negative returns. So, you can select a mutual fund that has a higher Sortino ratio.
Treynor Ratio
The Treynor ratio is also a risk-adjusted barometer. The formula of this ratio is the same as the Sharpe ratio in mutual fund but the only difference is that it takes beta rather than SD in the denominator.
If the beta is 10% and the rate of return of a mutual fund is 12% for a constant level of the risk-free rate of return, then the Treynor ratio showcases extra returns of 2% generated by the fund over the market. So, the higher the Treynor ratio of a fund, it is better.
Turnover Ratio
The portfolio turnover ratio in mutual funds is the percentage of overall portfolio holdings (including stocks and bonds) changed within a year. The fund manager analyzes the underlying portfolio and in order to generate higher returns, he buys or sells the holdings. So, if a fund has a higher turnover ratio, then it means its portfolio is changing at a faster speed.
For example, if a mutual fund buys stocks of ₹100 crores and sells ₹50 crores in a year. Given its AUM is ₹130 crores, then its portfolio turnover ratio will be (Minimum of stocks purchased or sold in a year/ Average AUM) x 100 = 50/130 *100 = 38.46%
There is no sure short way to select a fund on the basis of turnover ratio. The higher turnover ratio of a fund implies updated investment decisions but can have a higher mutual fund expense ratio. The lower turnover ratio could mean that the invested stocks are given time to perform and can grow in the long run.
Alpha Ratio in Mutual Funds
After going through the mutual fund expense ratio and other key ratios, let’s understand the alpha ratio. It helps in measuring how much return the fund has given over the benchmark index. It is a risk-adjusted measure and judges the ability of the fund manager to bring excess returns.
If the fund’s alpha is 2, then it has generated 2% higher returns than the benchmark. If the alpha value is -2, then it suggests that it has underperformed by 2% from the benchmark index. This signifies that you can select a fund that has a higher alpha.
Beta Ratio
The alpha ratio in mutual funds measures the returns, while beta analyzes the volatility or the systematic risk of a mutual fund against the benchmark index. The beta of the market or the stock market indices is 1 and any deviation from this represents how volatile the fund is. A beta of more than 1 means that the fund is more volatile and less than 1 indicates lower volatility.
For example, if the fund’s beta is 2% and the benchmark index Nifty rises by 1%, then the fund’s returns can rise by 2%.
There is no ideal rule to select the right beta fund and if you are a risk-averse investor, then you can select a fund that has a beta of less than 1. Or, if you can take the high risk to play with the volatility, then you can select the higher beta fund.
Standard Deviation
In the realm of mutual fund ratios, another measure of risk is the standard deviation which analyzes how much the fund’s returns have deviated from its average rate of return. Beta quantifies the riskiness in comparison to the benchmark index while SD denotes the volatility in line with its mean rate of return.
For example, if the SD of a fund is 2% and its annual average rate of return is 20%, then the fund can generate higher 2% or lower 2% returns than the average return. It is better to select a fund that has a lower SD because it is maximizing the returns for the level of risk it takes.
R-Squared
R-squared helps you in analyzing how the fund is correlated with the benchmark index’s returns. If an actively managed mutual fund has a high R-squared value, then you can rather consider an index fund because its mutual fund expense ratio is much lower.
R-squared value ranges from 0 to 100 and the index fund is likely to have a R-squared value of 100. A fund having a R-squared value between 70 and 100, means it has a high correlation with an index. Any value between 40 and 70 denotes average correlation, while values equal to or less than 40 imply less correlation.
Mutual Fund PE Ratio
The list starting from the mutual fund expense ratio has come to an end. PE (Price-to-earnings) ratio in a mutual fund is the weighted average of the PE ratio of all the invested stocks. As the fund’s underlying stocks change, so does the PE ratio of the fund.
If the fund’s PE ratio is high, then it means that the fund has invested more in overvalued or expensive stocks which is generally done in a growth investing style. If the fund’s PE ratio is lower, then it has taken the approach of value investing and has invested in undervalued stocks.
Conclusion
Every ratio stands on a different level and tells you about the benefits and risks of investing in a fund. The mutual fund expense ratio includes the cost of handling the fund. Sharpe, Treynor, and Sortino ratios compute the risk-adjusted returns considering different risks. Turnover and PE ratio informs about the quality of the invested portfolio. Alpha is the return measure, while beta and standard deviation inform about the risk and volatility.
It is good to invest in mutual funds after doing a detailed ratio analysis. Open the Demat Account on the SMC ACE App, get all the ratios handy, and invest on the go.
FAQs
What is a good expense ratio for a mutual fund?
Any percentage of the total expense ratio in mutual fund is good considering the fund generates competitive returns. If a fund’s expense ratio is lower than its category average, then it is considered healthier.
Is a high Sharpe ratio risky?
No, a high Sharpe ratio in mutual fund is not risky. It is considered good because the fund is generating better returns as compared to the risk it takes.
What is a good Sortino ratio for a mutual fund?
A Sortino ratio of at least 2 of any fund is generally good. But if it is lower than the category average, then it can turn bad.
What are the 5 ways to measure mutual fund risk?
The 5 ways to measure mutual fund risk are beta, standard deviation, Sharpe ratio, Sortino ratio, and Treynor ratio.
References :
https://www.investopedia.com/investing/measure-mutual-fund-risk/#toc-alpha
https://economictimes.indiatimes.com/mf/analysis/explainer-which-ratio-to-look-at-while-buying-a-mutual-fund/articleshow/109834012.cms
https://www.amfiindia.com/investor-corner/knowledge-center/understand-return.html
