How you can factor in risk in your expected mutual fund returns

Risk and return are closely related. They are often inversely proportional, with riskier assets potentially earning better returns than less risky assets. Still, mutual fund investors may only consider the returns a fund offers. They may ignore the risk, leading to losses if things do not go their way. Therefore, calculating risk-adjusted returns is the better approach to mutual fund investments. Read on to know why.

The meaning of risk-adjusted return

Risk-adjusted return differs from absolute returns because it calculates the returns an asset offers after factoring in the risk it brings. In mutual funds, risk-adjusted returns are calculated after evaluating the risk profile of each fund. It can help you choose from several mutual funds and provide a more realistic picture of your expected returns from a fund.

How is risk-adjusted return calculated?

Risk-adjusted returns can be calculated using several ratios. Each risk ratio provides unique insights and can give you an idea about different aspects of the risk-adjusted return. Let us see how.

Alpha

Matching the returns earned by benchmark indices is the minimum expectation from a mutual fund. Alpha allows you to measure this, which also proves helpful in determining the risk-adjusted returns of a fund. If the fund outperforms the index by a considerable margin, you may consider investing in it. The baseline for Alpha is 0, so funds with an Alpha over 0 may tend to outperform the benchmark index, and those with an Alpha below 0 may tend to earn fewer returns than the benchmark index.

Beta

Beta judges the volatility of a mutual fund against a benchmark index. It does so by analysing a fund's performance in several market conditions. If the fund manages to hold a firm in every condition, it is less volatile, and its Beta ratio will be less than one. Funds with a Beta ratio over 1 are more volatile than the benchmark index. In contrast, those with a Beta ratio of 1 are as volatile as the index.

Standard deviation

Standard deviation is a critical parameter that can help determine a mutual fund's risk-adjusted returns. It compares and tracks the difference in the returns a fund offers over a certain period to its average returns. A steady fund will tend not to deviate too much from its average returns.

Sharpe ratio

The Sharpe ratio measures the returns you get in proportion to the risk involved in an asset. It works on a simple logic: the returns earned by a mutual fund are compared to the returns of a risk-free asset. The difference is subtracted and divided by the standard deviation value. The fraction you get is the Sharpe ratio.

Mutual fund investments with a higher ratio may be preferred as they can provide better value for the risk you need to bear. Sharpe ratio in mutual funds can be calculated using the following formula:

Sharpe ratio = ( Rp – Rf ) / Standard deviation

Where:

Rp = Expected portfolio return, and

Rf = Risk-free rate

R-squared

The R-squared is a more detailed version of Alpha. Alpha tracks a fund's performance against a benchmark index. At the same time, R-squared measures the fund's movement in proportion to the movement in the index.

Treynor ratio

The Treynor ratio functions like the Sharpe ratio but uses the Beta ratio instead of standard deviation to calculate the adjusted returns of a mutual fund.

Sortino ratio

The Sortino ratio is another risk ratio closely related to the Sharpe ratio. However, unlike the latter, the Sortino ratio values the downside risk of a mutual fund. It divides the risk-adjusted returns with the downside risk to arrive at a value. The higher the Sortino ratio, the better the return per unit of risk undertaken.

Factoring in risk is vital for your mutual fund investments. It helps you make better investment decisions and safeguards your portfolio in testing market conditions. You may also get a better idea of your expected returns, which gives you better control of your finances.