Understand what risk-adjusted return is

Investing in mutual funds offers you a range of opportunities to grow your wealth over the long term. However, with the multitude of options available, it is crucial for you to understand the concept of risk-adjusted returns. 

This metric allows you to evaluate the performance of mutual funds while considering the level of risk that you take. Let us delve into the concept of risk-adjusted returns and explore how it affects your investments in mutual funds.

Understanding risk-adjusted returns

Risk-adjusted returns refer to the measure of an investment’s profitability while considering the level of risk associated with that investment. Simply put, it allows you to assess whether the return earned on a mutual fund justifies the amount of risk taken. By evaluating risk-adjusted returns, you can make more informed decisions by comparing various mutual funds on an equal footing.

Common measures of risk-adjusted returns

• Sharpe ratio

The Sharpe ratio measures the excess return earned by a mutual fund relative to the risk-free rate per unit of total risk. It takes into account the fund’s volatility and allows for comparison among funds with differing levels of risk. A higher Sharpe ratio indicates a better risk-adjusted return. Consider Fund A with an annual return of 12% and a standard deviation of 10%. If the risk-free rate is 5%, the Sharpe ratio would be (12% – 5%) / 10% = 0.7. In comparison, Fund B with an annual return of 15% and a standard deviation of 15% would have a Sharpe ratio of (15% – 5%) / 15% = 0.67. Although Fund B has a higher return, Fund A exhibits a better risk-adjusted return due to its lower volatility.

• Alpha

Alpha is a crucial component of risk-adjusted returns. It measures a mutual fund’s ability to outperform its benchmark index, considering the level of risk taken. A positive alpha indicates that the fund has performed better than expected, while a negative alpha suggests underperformance. Suppose a large-cap equity mutual fund generates a return of 12% in a year, while its benchmark index returns 10%. In this case, the fund’s alpha would be +2%, indicating its ability to outperform the market.

• Beta

Beta, on the other hand, helps assess the volatility or systematic risk associated with a mutual fund relative to the market as a whole. It measures the sensitivity of a fund’s returns to fluctuations in the benchmark index. A beta of 1 indicates that the fund’s price movements closely mirror those of the index. A beta greater than 1 implies the fund is more volatile, while a beta less than 1 indicates lower volatility. For instance, a beta of 1.2 suggests that the fund is likely to be 20% more volatile than the benchmark index.

Utilising risk-adjusted returns for informed decisions

When analysing mutual funds, it is essential to consider risk-adjusted returns alongside other factors such as historical performance, fund objectives, and expense ratios. By evaluating risk-adjusted returns, you can identify funds that have consistently delivered satisfactory returns while maintaining an acceptable level of risk. It helps align your investment goals and risk tolerance with the appropriate mutual fund.