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Stat Ratios - But Why?

An investor should keep in mind that mere returns of a fund are not adequate to make sound investment decisions as these figures do not reveal the complete story. ‘The end doesn’t justify the means’ holds true for investment portfolios as well. This is where the need for statistical analysis arises. Parameters like Alpha, Beta, R-square, Standard deviation and Sharpe ratio help an investor to better judge the fund's performance in the true sense. These five indicators account for the risk-return tradeoff associated with the investment in Mutual funds. Only the historical performance should not be considered while making a future investment decision. These tools provide the necessary information for investors to evaluate how effectively their money has been invested. Risk defined All investments have inherent risk attributes. Risk refers to the probability of losing money or failing to make money on an investment. But when the term is specifically used in the context of Mutual funds, it generally refers to an investor's ability to endure volatility. A fund with higher risk is usually expected to deliver higher return and vice versa. At the same time, a long term investment perspective helps investors to suffer relatively lower volatility than short term investments. Interpreting statistical ratios Alpha: It gauges the fund manager's ability to generate additional returns over the risk-adjusted returns delivered by the corresponding benchmark index. Investors can get an idea of how much value the fund manager through his stock selection ability has added (or eroded) to (from) the fund. Stock selection could be a combination of sound fundamentals and market timing. Alpha measures the excess returns generated over a statistically adjusted benchmark return. A high value for alpha implies that the fund has performed better than what has been expected. A positive alpha of 1 means the fund has outperformed its benchmark index by 1%. Similarly, a negative alpha of 1 signifies an underperformance of 1%. The higher the ratio, the better the risk-adjusted returns. Alpha = Portfolio Return - Benchmark Portfolio Return; Where: Benchmark Return = Risk Free Rate of Return + Beta (Return of Market - Risk-Free Rate of Return) Investors usually judge a fund manager by the return it gives, never by the risk he took to provide that return. The primary idea behind the concept of Alpha is that the fund manager should never be analyzed solely on the returns of the portfolio, the risk component associated with the investment should also be considered so as to get the correct picture. Let us take an example of a fund being managed by three fund managers at different times. Expected portfolio return, Risk-free rate of return and Market return are same for all three scenarios.

00% 10. Similarly if the market loses 10%.00% .00% Market Return 10. If a fund has a beta of 1.50% = 9.9. it is considered to have the same risk as the overall market.50% 9.10. However.2 and the market is expected to move up by 10%. which are poor indicators of future price movements.00% 10. Whereas. Hence.05 + 1. A fund with a beta greater than 1 is considered to be more volatile than the market and vice versa. Beta is calculated using regression analysis.05)} * 100 = B 20.05 + 0. Beta of an index is always taken as 1. Thus for investors with low risk appetite. It is a measure of the volatility of a portfolio in comparison to the market as a whole. Beta: Unlike Alpha.90 1.10-0.00 (0.10-0.00% 5.00% = 10.00% {0.50% From the above cited example.00% .05 + 1. or more specifically it gauges the tendency of a fund's returns to respond to the market fluctuations.10 Risk-Free rate of Return 5.00 1.10.90 (0.10 (0.05)} * 100 = C 20.00% . the fund should move by 12% (obtained as 1.50% = 10. it is evident that Manager A did best as he generated the maximum Alpha.Fund Manager A B C Portfolio Return 20.00% 10. If the fund has a beta of 1.00% 5. investment in stocks / funds with low beta is preferred.00% Calculation of Expected Benchmark Return and Alpha Fund Manager Expected Benchmark Return Alpha {0. So by multiplying the beta of a fund with the expected percentage movement of an index. which measures the excess returns over the benchmark index.2 multiplied by 10).00% 20. investors willing to take higher risk.00% 20. Beta accounts for the excess risk over the index. the expected movement in the fund can be determined. Where: Rp is the Portfolio rate of return Rm is the Market rate of return To illustrate it with an example.50% 10.10-0. the problem is that Beta considers past price movements for calculation purpose. should invest in high beta stocks / funds.05)} * 100 = A 20. Beta can be considered as a . the fund should lose 12% (obtained as 1.2 multiplied by minus 10).00% Beta 0.50% {0.

Hence. . It measures the percentage of the fund’s variations that is attributable to the movements in the benchmark index. an Rsquared value of 1 indicates no correlation. More specifically. an investor cannot figure out the whole investment scenario. it can be stated that 70% of its profits or losses are due to market gains. R-Squared: The R-squared value explains the extent to which the beta value is reliable. the investors should also consider the risk associated with the investment. which could cause unreliable investment decisions. Where: X is the Portfolio Y is the Market To cite an example. it is clear that beta is reliant on the index that is used to calculate it. The rest 30% are the consequence of other factors. the resulting beta value might not hold any significance if the fund and the corresponding index is not correlated to each other. A high return is not good enough to lure investors. whereas. An R-squared value of 1 indicates that the fund and the index are perfectly and closely correlated to each other. Conclusion (The Bottom Line): Besides looking into the funds’ returns. Values for r-squared ranges from 0 and 1. From the above concept of Beta. and the movements of the portfolio are entirely explained by the movements in the benchmark. it's less useful. However. Beta and R-squared must be used together to judge a fund’s risk profile.7 shows that 70% of the portfolio’s returns are the outcome of the market changes.good measure for short term investors but for investors with long-term horizons. The explanation of the above statistical ratios would provide an insight into the risk adjusted return of the funds under consideration. it is recommendable only if it is not associated with a high risk. Without assessing risk-adjusted returns. An R-squared of 0.