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Do not Ignore An Investment's Risk Level!
April 21, 2009

When it comes to selecting a mutual fund, its performance should not be the only factor that investors take into account. The fund risk level is also a crucial consideration. We explain why a fund's Sharpe Ratio and Risk Return Ratio can say a lot about its risk level, and how investors can find these information at our fund Selector and fund factsheets.


Author : iFAST Research Team



Untitled Document

Many a time, investors would focus on a mutual fund's performance when deciding on what fund to buy. However, while that is an important factor to consider, we believe it is also important for investors to examine other factors, including those which indicate an investment's risk level. In this article, we explain why the Sharpe ratio and the Risk-return ratio are good proxies to do just that.

What Is A Sharpe Ratio?

The Sharpe Ratio measures an investment's excess return per unit of risk. The excess return is calculated by finding the investment's return in excess of that from a risk-free asset. The risk free asset in India is the 10 year government bond. This ‘excess return' is then divided by the investment's volatility level, which can be measured by the standard deviation of the returns.

 sharpe ration formula
The Higher The Shape Ratio, The Better The Portfolio's Performance

The Sharpe Ratio can be used to compare the performance of a portfolio or fund manager, relative to their peers. When the Sharpe ratio is used to rank the performance of a fund manager, it indicates the excess return that the fund manager can deliver to investors per unit of risk that the fund manager is taking.

Hence, the higher the Sharpe ratio, the better the investment's performance. However, investors should compare the Sharpe ratio of mutual funds which have a similar investment objective, and invest in the same sector. For example, from the numerous diversified equity funds distributed on our platform, investors can compare the Sharpe ratio of these funds to find which one can provide better risk-adjusted returns.

What is a Risk-return Ratio?

The Risk Return ratio is a simpler version of the Sharpe ratio. It measures the return per unit of risk, but does not take into account the excess return from an investment's return above that of a risk-free instrument. Therefore, the Risk-return ratio takes the portfolio's return, and its volatility (standard deviation) to measure the investment's risk level.
Risk return formula

Generally speaking, the Risk-return ratio is similar to the Sharpe ratio. Both of them are used to measure the return of a mutual fund for every unit of risk taken. Investors can compare the two ratios for the mutual funds which are invested in the same asset class or sector. When a mutual fund's Shape ratio and Risk Return ratio are higher than those of its peers, this means that the fund gives a better return for a given unit of risk.

Conclusion

The Sharpe Ratio and Risk Return Ratio are measures that are commonly used for comparing the performance of mutual funds or portfolios, and the way that the fund manager manages risk and performance, as the ratios provide an indication of the level of risk borne by the fund manager in the process of running the fund or portfolio. We believe that a good fund manager should be able to deliver good returns, but must also manage the volatility of the fund effectively. In other words, a good fund should have a better-than-average Sharpe ratio or Risk Return ratio. Information for the two ratios can be found in the Fund Selector; investors can also refer to our fund factsheets for the Sharpe Ratios of specific funds.

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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