These statistical tools are used by fund managers to understand the risk-reward profile of a mutual fund.

Though these involve complex formulae, you don't need to calculate all of them. Simply knowing the final figures and what the ratios indicate will help you analyse the fund. Where can you find these tools? The five indicators: standard deviation, Sharpe ratio, beta, r-squared and alpha are easily available for free on Websites such as valueresearchonline.com and morningstar.co.in. It is a measure of a mutual fund's volatility. HOW TO INTERPRET IT: It measures the degree to which a fund's return fluctuates in relation to its average return over a period of time. The higher the standard deviation, the more volatile the fund, and hence, more risky as the fund's performance will rise and fall drastically in a short period of time. KEEP IN MIND: Usually, as standard deviation increases, so does the return due to the risk-return trade-off. But if two funds with same investment objectives deliver similar returns, the one with the lower deviation is a better choice as it maximises the returns for the given risk level. So, while HSBC Equity and DWS Alpha Equity aim at capital growth from diversified stocks and have performed similarly, the latter has a higher deviation.

The ratio explains whether the fund returns are due to intelligent investment decisions or the result of excessive risk taken by the fund manager. HOW TO INTERPRET IT: It is measured by subtracting the risk-free return from the fund's return and dividing the result by the standard deviation of its return. The risk-free return in India is considered either to be the bond rate or 181-day treasury bill rate. The higher the ratio, the better is the fund's risk-adjusted performance. KEEP IN MIND: A fund may fetch higher returns than its peers, but it's usually a good option only if it doesn't take too much risk in doing so. Take Reliance Equity Opportunities and BNP Paribas Dividend Yield. The former multicap fund has earned higher returns, but it also has a lower Sharpe ratio. It's also a measure of volatility and tells how risky a fund is in comparison to the market. HOW TO INTERPRET IT: It measures the sensitivity of a fund's return to swings in the market. The market's beta is always 1. The index funds' beta value is equal to that of the market. If the beta is less than 1, it indicates less volatility than the market, and vice-versa. KEEP IN MIND: Conservative investors whose focus is capital preservation should look at funds with low betas as their values are less likely to decline than those of the benchmark index in a bear phase. The table shows the performance of two funds relative to their benchmark (S&P CNX Nifty) during the bear phase-9 January 2008 to 5 March 2009. Birla Sun Life Asset Allocation Aggressive has a lower beta and fell less than the benchmark. The ratio explains how closely a fund's performance correlates with the performance of the overall market. HOW TO INTERPRET IT: It measures the percentage of a fund portfolio's movement that can be explained by the movement of the benchmark index. R-squared values range from 0 to 1, where 0 indicates no correlation, while 1 indicates perfect correlation. KEEP IN MIND: Avoid investing in the actively managed funds that have higher expense ratios and are still perfectly correlated with the index as it will be better to invest in an index fund. In the example, ING Large Cap Equity has the same R-squared as an index fund. The 3-year returns of the fund are only 0.5% higher than the index fund, while there is a differential of 1.5 % in the expense ratio. t quantifies what the fund manager brings or takes away from the return of an investment, which is based on his skill and value addition that he provides. HOW TO INTERPRET IT: It is a measure of performance on a risk-adjusted basis. Alpha considers the price volatility of the fund and compares its risk-adjusted performance with that of the benchmark index. The excess return of the fund relative to benchmark index is called alpha. A positive alpha of 1 means that the fund has outperformed its

benchmark index by 1%, and a similar negative alpha indicates an underperformance of 1%. KEEP IN MIND: Funds with negative alpha are not good options as it means the fund manager is not generating any value-added return in excess of the market. The more positive an alpha, the better it is. In reality, few fund managers create a meaningful alpha that negates the expenses of the scheme. The table below shows that HDFC Top 200 has generated significant alpha, while UTI Contra has not, and JM equity has created a negative alpha.

Mutual Funds: Evaluating Performance

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Perhaps you've noticed all those mutual fund ads that quote their amazingly high one-year rates of return. Your first thought is "wow, that mutual fund did great!" Well, yes it did great last year, but then you look at the three-year performance, which is lower, and the five year, which is yet even lower. What's the underlying story here? Let's look at a real example from a large mutual fund's performance:

1 year 3 year 5 year 53% 20% 11%

Last year, the fund had excellent performance at 53%. But, in the past three years, the average annual return was 20%. What did it do in years 1 and 2 to bring the average return down to 20%? Some simple math shows us that the fund made an average return of 3.5% over those first two years: 20% = (53% + 3.5% + 3.5%)/3. Because that is only an average, it is very possible that the fund lost money in one of those years. It gets worse when we look at the five-year performance. We know that in the last year the fund returned 53% and in years 2 and 3 we are guessing it returned around 3.5%. So what happened in years 4 and 5 to bring the average return down to 11%? Again, by doing some simple calculations we find that the fund must have lost money, an average of -2.5% each year of those two years: 11% = (53% + 3.5% + 3.5% - 2.5% - 2.5%)/5. Now the fund's performance doesn't look so good! It should be mentioned that, for the sake of simplicity, this example, besides making some big assumptions, doesn't include calculating compound interest. Still, the point wasn't to be technically accurate but to demonstrate the importance of taking a closer look at performance numbers. A fund that loses money for a few years can bump the average up significantly with one or two strong years. It's All Relative Of course, knowing how a fund performed is only one third of the battle. Performance is a relative issue, literally. If the fund we looked at above is judged against its appropriate benchmark index, a whole new layer of information is added to the evaluation. If the index returned 75% for the 1 year time period, that 53% from the fund doesn't look quite so good. On the other hand, if the index delivered results of 25%, 5%, and -5% for the respective one, three, and five-year periods, then the funds results look rather fine indeed.

To add another layer of information to the evaluation, one can consider a funds performance against its peer group as well as against its index. If other funds that invest with a similar mandate had similar performance, this data point tells us that the fund is in line with its peers. If the fund bested its peers and its benchmark, its results would be quite impressive indeed. Looking at any one piece of information in isolation only tells a small portion of the story. Consider the comparison of a fund against its peers. If the fund sits in the top slot over each of the comparison periods, it is likely to be a solid performer. If it sits at the bottom, it may be even worse than perceived, as peer group comparisons only capture the results from existing funds. Many fund companies are in the habit of closing their worst performers. When the "losers" are purged from their respective categories, their statistical records are no longer included in the category performance data. This makes the category averages creep higher than they would have if the losers were still in the mix. This is better known as survivorship bias. (Learn more about survivorship bias in The Truth Behind Mutual Fund Returns.) To develop the best possible picture of fund's performance results, consider as many data points as you can. Long-term investors should focus on long-term results, keeping in mind that even the best performing funds have bad years from time to time. (Dig into the numbers in Mutual Fund Ratings: Are They Decieving?)

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