Ratios which Investors should consider while choosing Mutual Fund Schemes
by Mirae Asset Knowledge Academy
Investing by considering only historical returns in a mutual fund
scheme is risky. Investors need to evaluate the risk involved in mutual fund schemes
before investing. There are no of ratios which mutual fund investors should
consider before making their investments. In this article we will
cover Jensen’s Alpha ratio
Definition:
The simplest definition is the excess returns of the fund over the benchmark. Alpha is performance ratio to measure risk-adjusted performance of a portfolio, intended to help investors determine the risk-reward profile of a mutual fund.
Alpha measures the difference between a fund's actual returns and its expected performance, given its level of risk. A fund's alpha is often considered to represent the value that a portfolio manager adds to or subtracts from a fund's return above and beyond a relevant index's risk/reward profile.
Jensen's alpha was first used as a measure in the evaluation of mutual fund managers by Michael Jensen in 1968.
Computation:
Alpha = {(Fund return-Risk free return) – (Funds beta) *(Benchmark return- risk free return)}.
Example:
Fund return 10%
Risk free return 8%
Benchmark return 5%
Beta of Fund 0.8
By computing with above formula we will get alpha as 4.4 for this fund
Significance
The Alpha as represented by percentage indicates under performance
or Outperformance of a portfolio.
- A positive alpha means the fund has outperformed its benchmark index. Correspondingly, a negative alpha would indicate an underperformance.
- As a fund's return and its risk both contribute to its alpha, two funds with the same returns could have different alphas.
Investors are often advised to pick funds with high Jensen Alpha ratios.
Weaknesses
o In some cases, a negative alpha can result from the expenses that are present in the fund figures but are not present in the figures of the comparison index.
Sharpe ratios, along with Treynor ratios and Jensen's alphas, are often used to rank the performance of portfolio or mutual fund managers.
Alpha is one of five technical risk ratios; the others are Beta, Standard
Deviation, R-squared, and the Sharpe ratio. These are all statistical
measurements used in modern portfolio theory (MPT). All of these indicators are
intended to help investors determine the risk-reward profile of a mutual fund.
We will be explaining Beta and Standard Deviation in our next week article.
Mutual fund investments are subject to market risks, read all scheme related documents carefully.
