Fact Check: Mutual Fund Metrics Explained – Alpha, Beta, Sharpe Ratio & More

hi welcome to the 10th video in the mutual fund series and in this video we will discuss a few mutual fund metrics

that you need to know as usual let me start with another story when I was in school I had a bunch of

friends who would get hyper competitive just around the exams their aim was not just to score well in the exam but also

score better than some of their friends I still remember this incident very clearly the results of physics paper was

out and it was a super difficult paper to crack while the rest of the class hoped that

they would clear the paper they were these two guys who had scored amazingly well

one of them was my friend my friend had scored 93. far better than the rest of the class

but there was this other guy who had scored 95. his friend of mine was just not happy

for him The Benchmark was not the rest of the class but this other guy who had scored 95 benchmarking in a sense is

very good it pushes you to perform better mutual fund schemes are also benchmarked

The Benchmark is selected in such a way that it makes sense for example a large cap mutual fund is benchmarked against

nifty 50 which is basically a large cap index it does not make sense to Benchmark a large Cap Fund with a small

cap index so when you evaluate a mutual fund one of the most basic check is to see how the mutual fund has performed

relative to The Benchmark but that said more than checking the mutual fund's performance against its Benchmark what's

more important is managing your own expectation if you've invested in a large Cap Fund

expect large cap kind of returns do not expect small cap fund returns next up is the beta of a mutual fund

the beta for mutual fund measures the relative risk of the mutual fund with respect to its Benchmark here is the

beta of Tata multi-cap fund as you can see the Tata multi-cap fund is benchmarked against s p BSE 500 as you

can see beta of this fund is 0.95 if the beta is less than 1 then it's expected that the fund is less risky compared to

its Benchmark if it is equal to 1 the fund is as risky as The Benchmark if the beta is higher than 1 then the fund is

expected to be far more riskier than the Benchmark itself one super important thing to remember when you're looking at

beta beta gives you the relative risk of the fund with respect to its Benchmark but the beta does not tell you anything

about the inherent risk of the fund itself to put this in context we all understand a Ferrari is much faster than

probably a maruti this comparison is like evaluating the beta all it tells us is that the Ferrari is

faster than the maruti but it does not tell me anything about how fast the Ferrari is traveling or the maruti car

is traveling let's discuss the next metric the alpha most people tend to think that the alpha

is a measure of outperformance of the fund with respect to its Benchmark for instance if the Benchmark has delivered

seven percent and for the same time period the mutual fund has delivered 10 percent then the alpha is perceived as 3

percent while this is broadly true in the context of mutual fund Alpha is slightly different Alpha in the context

of mutual fund measures the excess return Over The Benchmark but on a risk-adjusted basis so we basically need

to evaluate the outperformance of the mutual fund with respect to its Benchmark by considering a risk-free

rate and for the risk-free rate you can always check the yield on a one year treasury bill given this here is the

formula to calculate the alpha for mutual fund assume a certain fund has given you a return of 10 percent its

Benchmark returns for the same duration is seven percent the beta of this fund is 0.75 how much

do you think is the alpha assuming there is free rate is 4 percent well if you apply the formula of alpha

you will get the alpha as 3.75 percent needless to say higher the alpha the better it is the next mutual fund metric

that I want to touch upon is the standard deviation [Music]

standard deviation and grain detail across various different modules in Varsity so I'll take the Liberty to keep

this short the standard deviation of a mutual fund gives you a sense of how risky the mutual fund is the standard

deviation is a percentage expressed on an annualized basis higher the standard deviation higher is the volatility

higher is the risk next up is the sharp ratio of a fund shop ratio is one of the most sacred

formulas in finance it was invented in the year 1966 by an American Economist called William F sharp William sharp

even won the Nobel Prize in 1990 for his work on Capital asset pricing model assume there are two large cap funds fun

day and fund B and here is how they're performed in terms of returns which of these two funds do you think has

performed better well it's a no-brainer fund B has delivered higher returns therefore fund B is a better choice here

now let's add some more information along with the returns of the fund I've also included the risk or the standard

deviation of the fund and also a certain risk-free rate now given all this information which of the two funds do

you think is better well if you were to evaluate fund based on risk then fund a is better as it has a lower standard

deviation compared to fund B and if you were to evaluate the fund based on returns then fund B is better

as it has delivered higher returns than one day but in reality you will have to choose a fund both based on risk and

return you cannot isolate risk and return and evaluate a fund and this is where sharp ratio helps us the sharp

ratio of a fund is the excess Return of the fund over the risk-free rate divided by the standard deviation of the fund if

you apply the sharp ratio Formula to fund a you'll get the sharp ratio as 0.29 what this number conveys is that

for every unit of risk the return is 0.29 over and above the risk-free rate well by this measure higher the sharp

ratio the better it is as we all want higher returns for every unit of risk let's apply the sharp ratio to fund d as

you can see fund B also has a sharp ratio of 0.29 so it turns out both the funds are similar in terms of sharp

ratios there's no real advantage in choosing fund a over fund B now let's change the standard deviation of fund B

from 34 to 18 percent and reapply the sharp ratio Formula as you see the sharp ratio is now bumped

up to 0.5 what this means is that for every unit of risk that the fund takes the return is 0.56 higher than the

risk-free rate which obviously is very good do note sharp ratio only considers price

based risk it does not consider credit risk default risk and all the other risks applicable to a debt fund which

implies that you should use sharp ratio only for an Equity Fund and not to a debt fund let's move ahead and discuss

the last metric the capture ratios [Music] a benchmark as you know is Market linked

any Market linked instrument will have both positive and negative Returns the capture ratio tells us for a given

period to what extent that the fund capture the positive returns of the Benchmark and also to what extent it

will capture the negative returns of the Benchmark here is an example these are the capture ratios of htfc top 100 fund

this is direct growth these capture ratios are on a three-year basis and I've taken this from the

morning stars India website the fund has a upside capture ratio of 99. this implies that the fund has managed to

capture 99 of the indexes up move the downside capture ratio is 119. this implies that the fund has captured 119

percent of the downside returns of the index the upside capture ratio conveys to the extent to which the fund captures

all the positive returns of the benchmark the downside capture ratio indicates the

extent to which the fund captures or rather avoided all the negative returns of its Benchmark given this ask yourself

what should be the ideal capture ratio of a mutual fund well you would want a mutual fund which would capture hundred

percent of the up move if not more and you would want the downside capture ratio to be minimum well this is not

easy the fund will either have a great upside capture Ratio or a great downside capture ratio but not both personally I

like funds which manage risk better and I evaluate this by looking at the consistency of downside capture ratio

across multiple Years anyway metrics like benchmarking beta Alpha standard deviation sharp ratio and capture ratio

these are some of the most basic metrics that you will have to know as a DIY mutual fund investor and in the next

video we'll use all these metrics to analyze an equity mutual fund do comment and let me know if you have any queries

I'll see you guys soon