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'Look before you leap': How important are risk and expense ratios while selecting funds?
March 10, 2010

In this article, we seek to explain the more commonly-used risk and expense ratios and the significance of each ratio.


Author : iFAST Research Team



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While investing in mutual funds, investors usually look at the fund’s performance and investment style to decide which funds to invest in. More often than not, they tend to ignore risk and/or expense ratios in their decision-making process. They lack the understanding of such ratios or do not realize their importance.  

So the key question for investors to consider is, whether these ratios are important in deciding which mutual funds to invest in?

In this article, we discuss the more commonly-used ratios and the significance of each ratio. To summarize, this table provides an overview of the ratios:

 

Ratios

What does it measure?

Indication for the investor

1

Annualised Volatility

The riskiness of the fund

A fund with lower annualised volatility is considered to be less risky.

2

Beta

The relation of the fund’s performance with that of the market or index

A positive beta means that the fund's performance is directly related to the market.

A negative beta means the fund's performance is inversely related to the market.

3

Sharpe Ratio

The risk-adjusted return of the fund

Higher the value of  Sharpe ratio, the more attractive is the fund

4

Expense Ratio

The total expenses of the fund.

Lower the total expense ratio of the fund, the more attractive is the fund

5

Portfolio Turnover Ratio

The frequency of trading within a fund.

Lower value of turnover ratio indicates lower trading expenses.

Higher value of turnover ratio indicates active portfolio management for better returns.

a) Risk Ratios

Let us explore the risk ratios in detail:

  • Annualised Volatility

Annualised Volatility is used to quantify how risky the mutual fund scheme is. The deviation in the returns from the fund for certain number of years from its average returns is compounded and calculated to get the annualised volatility value of the fund. In other words, it is a measure of the standard deviation of compounded returns over a period of time, where standard deviation is understood to be the variation from the mean.

Let’s compare the two funds’ performance to understand this concept.

Year

Fund A Returns

Fund B Returns

2005

39%

16%

2006

-15%

18%

2007

28%

17%

2008

12%

10%

2009

21%

24%

Mean

17%

17%

Annualised Volatility

20%

5%

Although, the average returns of Fund A and Fund B over the five year period are same at 17%, it is easily seen that Fund B’s returns are more consistent than Fund A’s. As such, the annualised volatility for Fund B is 5% whereas for Fund A it is at 20%. Hence, the funds with higher annualised volatility are deemed to be riskier than the funds with lower annualised volatility.

Limitations

While the annualised volatility shows statistically how much a fund’s returns are varied, famous investment gurus like Warren Buffett dismiss the use of annualised volatility to determine the riskiness of any financial instrument. Warren Buffett’s argument is simple; he feels that risk should be determined by real risk of the underlying assets. For example, a stock’s risk should not be determined by the swing in its share prices, rather it should be determined whether the business is fundamentally sound or not. The movement in share prices can be manipulated by market participants and will be an inaccurate assessment of the risk of the underlying asset. Likewise, for a traditional equity fund, the fund’s inherent risk should be determined by evaluating the underlying shares that the fund invests into.

Nevertheless, annual volatility does give some insight into the consistency of the fund manager in delivering returns. However, investors are advised to consider the portfolio composition and the underlying shares to evaluate the fund further.

  • Beta

Beta is calculated by the following formula:

Beta = (Covariance of returns of the fund and index)/ (Variance of the index)

Beta is important because it tells us the relation of the fund’s performance compared to the market index/benchmark. Beta’s value ranges from negative to positive. A negative beta signifies inverse relationship while positive beta signifies direct relationship.

To illustrate, assuming Fund A has a beta of +1, it means that the fund performs in perfect tandem with the market/benchmark. On the other hand, a negative beta means that the fund will produce opposite results with respect to the market.

There is no ideal value for Beta. Investors who are keen on gaining exposure to a particular market could purchase mutual funds with positive beta with relation to that market. On the contrary, if an investor knows that a particular market is going to perform badly for a particular year, he could purchase a fund with negative beta to that market so that he can profit from it.

  • Sharpe Ratio

Sharpe ratio which is commonly known as reward-to-variability ratio is a measure of excess returns per unit risk.

It is calculated using the following formula:

Sharpe Ratio = (Fund Returns – Risk Free Returns)/Standard Deviation of Fund

Sharpe ratio is used to indicate how well the fund compensates the investor for the risk taken when investing in the fund. Hence, funds with higher Sharpe ratio are deemed to be more attractive than those with lower Sharpe ratio.

Sharpe Ratio is especially useful while comparing funds of same investment theme and geographical boundaries. This measure allows investors to differentiate outstanding funds from mediocre ones quite easily. For example, Fund A and Fund B invests in mid-caps companies. Fund A has a Sharpe ratio of 2 while Fund B has a Sharpe ratio of 0.5 so an investor would prefer to invest in Fund A as it can provide more risk adjusted returns over Fund B.  

 
b) Expense Ratio

  • Total Expense Ratio

Total Expense Ratio (TER) measures the total cost of investing in a fund for an investor. The components of TER usually consist of the following:

  • Annual Management Charge – The fee charged by the fund manager for managing the fund. It is usually fixed at a percentage of the fund’s Assets under Management (AUM)

  • Trustee, Audit and Legal Fees – The fees incurred to ensure that the fund is compliant with the regulations

  • Transaction Fees – The cost incurred in buying or selling underlying assets for rebalancing/ subscription/redemption purpose

Expenses erode the fund’s performance, as the fees are paid out of the AUM. Hence, a fund with lower charges or TER would be deemed more attractive than the one higher TER. As per the SEBI regulation, the expense ratio cannot exceed 2.5% and 2.25% of the net assets of mutual funds within equity and debt class respectively. The expense ratio is more critical for liquid and income funds because a high expense ratio will eat away the returns from your fund. Thus, a cost-effective fund would generate better returns over its peers.

  • Portfolio Turnover Ratio

Portfolio Turnover ratio measures how frequently the fund manager churns the assets within a fund. This ratio is directly related to transaction fees mentioned in the previous section. A fund with high portfolio turnover will incur more transaction fees than a fund with comparatively lower portfolio turnover.

This ratio also helps in giving insight about the fund manager’s style of investing. Should the style of investing run contrary to the fund’s investment philosophy, investors could consider selling that fund. Assuming, there is a fund that has professed to follow value investing closely. The philosophy could be to buy shares at low valuation and hold them, yet the fund has a high portfolio turnover. This could mean that there is a philosophy-style mismatch and investors who like to invest in funds with value-orientation may consider switching the investment into another fund. Depending on the fund’s investment philosophy, an investor can evaluate whether the fund’s turnover ratio is considered excessive or necessary.

Conclusion

Using the often-neglected risk and expense ratios, an investor can gain more insight that is essential in making profitable investment choices. The risk and expense ratios discussed in this article will give investors a holistic view while comparing similar mutual funds with almost equal returns. So a fund which delivers superior risk-adjusted returns and has lower expense ratio is a better bet for your portfolio.

 

Do YOU THINk these ratios will help you choose funds?

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iFAST and/or its content and research team’s licensed representatives may own or have positions in the mutual funds of any of the Asset Management Company mentioned or referred to in the article, and may from time to time add or dispose of, or be materially interested in any such. This article is not to be construed as an offer or solicitation for the subscription, purchase or sale of any mutual fund. No investment decision should be taken without first viewing a mutual fund's offer document/scheme additional information/scheme information document. Any advice herein is made on a general basis and does not take into account the specific investment objectives of the specific person or group of persons. Investors should seek for professional investment, tax, and legal advice before making an investment or any other decision. Past performance and any forecast is not necessarily indicative of the future or likely performance of the mutual fund. The value of mutual funds and the income from them may fall as well as rise. Opinions expressed herein are subject to change without notice. Please read our disclaimer in the website.

 


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