Risk adjusted returns in mutual funds

Investing in mutual funds offers the potential for creating wealth, but along with this potential come many risks. However, understanding the concept of ‘risk-adjusted returns’ can help investors choose suitable schemes that are in line with their risk appetite and financial objectives.

Let’s see how risk-adjusted returns work and how to adjust returns in mutual fund.

• Table of contents

1. What is risk-adjusted return?
2. Factors affecting-risk adjusted mutual fund returns
3. How to assess risk-adjusted returns in mutual fund?
4. Calculation and interpretation of risk adjusted returns
5. Why consider risk before investing?
6. What makes a good risk-adjusted return?
7. Key takeaways

What is risk-adjusted return?

Risk adjusted returns is used to measure an investment's return by examining how much risk is taken in obtaining the return. These returns are usually shown as a ratio, and higher values are generally seen as positive and indicative of a healthy investment. It enables the investor to make comparison between the high-risk and the low-risk return investment. By evaluating risk-adjusted return, investors can judge whether they are obtaining the highest possible gains with minimal risk involved and thereby the returns on investment.

Factors affecting-risk adjusted mutual fund returns

Several factors can influence risk-adjusted mutual fund returns. Here are some of them:

• Asset allocation: Funds with a higher proportion of risky assets like equities tend to be more volatile (and therefore riskier), but also have a relatively higher return potential. Debt-heavy funds offer lower volatility and risk, but also a relatively lower return potential. The fund manager's skill lies in finding the right mix of assets for the desired risk-adjusted returns.
• Volatility: Funds with high volatility experience significant swings in price, potentially leading to short-term losses. Lower volatility, on the other hand, indicates a smoother ride, but may come at the cost of a relatively lower return potential.
• Fund management: A competent fund manager can significantly influence risk-adjusted returns. Their ability to counter market movements, select promising assets, and manage risk plays a crucial role in optimizing the return potential while mitigating the impact of volatility.
• Benchmark: Risk-adjusted returns are often measured against a benchmark, like a market index. Comparing a fund's performance to its benchmark helps assess whether it's generating excess returns (beyond market movement) for the risk it takes.

How to assess risk-adjusted returns in mutual fund?

Investors can use various tools to gain specific information about risk-adjusted returns on their investments. Let's have a closer look at risk-adjusted returns and how they can be measured:

• Alpha: If you want to know how well an investment is doing, then alpha is a good measure. It is simply the measure of an investment against a benchmark index such as the Sensex, Nifty, etc. Alpha indicates the ability of the fund manager or portfolio manager because you can evaluate if you are getting returns that are outperforming the benchmark.
• Beta: A measure of volatility, beta indicates how much risk is involved in an investment as compared to the broader market. A beta value higher than 1 indicates relatively higher volatility in the chosen investment as compared to the market.
• Standard deviation: Standard deviation measures how much an asset's returns vary over a specified period compared to its mean or average returns. This is a useful measure since you can learn more about how steady the asset's returns are.

Calculation and interpretation of risk adjusted returns

Additionally, the following metrics can help investors to quantify their risk-adjusted returns:

• Sharpe ratio: Compares average return to volatility, with a higher ratio indicating better risk-adjusted performance.
• Sortino ratio: Focuses on downside risk (losses), making it ideal for assessing the options for defensive investors.
• Treynor ratio: Measures return per unit of market risk, helpful for evaluating actively managed funds against benchmark indices.
• Jensen's alpha: Evaluates a fund's performance relative to a benchmark, thus helping to identify outperformers.

Why consider risk before investing?

Assessing risk is essential for creating a robust financial strategy. Here’s why:

Understanding potential losses: Risk involves possibility of losing part or all of your invested capital. Different investments carry different risk levels, so it’s crucial to understand the possible losses and determine what you can afford to lose.

Aligning with your risk tolerance: Each individual has a unique risk tolerance, which determines how much risk they are willing to take. Some people are comfortable with higher risk for the chance of better returns over time, while others prefer low-risk investments. Understanding your risk tolerance helps you select investments that align with your comfort level.

Setting realistic expectations: Risk and return are closely connected. Investments that offer higher return potential also come with a higher risk of losses, while lower-risk options typically entail lower return potential.

Making informed decisions: Knowing the risks of different investments allows you to make informed decisions about where to allocate your money. You can balance potential rewards with possible losses and choose investments aligned with your financial goals and risk tolerance.

What makes a good risk-adjusted return?

A suitable risk-adjusted return is one where the return is reasonable for the level of risk involved. So, if two investments give the same return over a period of time, the one that did so by taking lower risk would have offered better risk-adjusted returns. This number of figure can vary depending on the method of calculation. Some common risk measures alpha, beta, standard deviation, Sharpe ratio, Sortino ratio, Information ratio and more.

Consistency in risk-adjusted returns across different market cycles is also important as it signals a strong investment strategy.

Key takeaways

Risk-adjusted return is a critical measure for evaluating investments because it provides insight into how much return an investment generates in relation to the risk taken. Simply put, it helps investors assess whether the returns justify the level of risk involved.

Different methods to assess risk-adjusted return

Sharpe Ratio: It calculates the excess return earned per unit of volatility (risk). It takes into account the portfolio return and risk-free rate of return and divides it by standard deviation

Treynor Ratio: Similar to the Sharpe ratio, the Treynor ratio measures the return earned above the risk-free rate per unit of systematic risk (beta) instead of standard deviation.

Alpha: Alpha measures an investment's performance relative to a benchmark index, taking into account its level of risk.

Beta: Beta is a measure of an investment's volatility in relation to the broader market.

Standard Deviation: Standard deviation measures the total volatility or variability in an investment’s returns.

Conclusion

In mutual fund investments, it's crucial to check risk-adjusted returns. Instead of just looking at the returns, investors must also factor in the risk involved. This way, one can get a better idea of how well a fund is performing relative to the risk taken. Deploying this strategy effectively can help investors in choosing investment options according to their risk appetite.

FAQs

What is risk-adjusted return?

Risk-adjusted return is a measure that considers the level of risk associated with an investment, providing a more holistic view of a fund's performance by factoring in volatility and risk factors.

Why is it important to consider risk when investing in mutual funds?

Considering risk is crucial as it helps investors gauge the potential downside of an investment. Understanding risk allows for a more informed investment decision-making process aligned with individual risk tolerance.

How does volatility impact risk-adjusted returns in mutual funds?

Volatility directly influences risk-adjusted returns; higher volatility often leads to a higher level of risk. Evaluating how well a fund compensates for this volatility is key to assessing its risk-adjusted performance.

What is the significance of risk-adjusted returns in mutual fund investments?

Risk-adjusted returns measure how much return an investment generates for each unit of risk taken. They help investors compare mutual funds with similar return profiles but different risk levels. A higher risk-adjusted return indicates positive performance for the level of risk assumed.

What are the common metrics used to calculate risk-adjusted returns?

Common metrics include the Sharpe Ratio, Treynor Ratio, and Jensen's Alpha.

How can investors assess risk-adjusted returns before choosing a mutual fund?

Investors can review the fund's factsheet or consult financial websites for these ratios. Compare the risk-adjusted return of a fund with its benchmark and peer group.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully. This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.