Explained: Want to choose the right mutual fund? Check these 10 key ratios

Mutual fund investors often focus heavily on a scheme’s past performance when making investment decisions. However, choosing the right mutual fund can be challenging, given the wide range of options available. Investors should look beyond returns and consider several other important parameters and ratios to make a more informed choice.

Relative return comparison is one way to evaluate a mutual fund manager’s performance. However, this approach does not account for differences in the level of risk taken by two schemes pursuing the same investment objective. Even when two schemes have the same benchmark, they may assume different levels of risk.

Therefore, judging performance solely on relative returns may be unfair to a fund manager who takes lower risk but delivers returns similar to those of a peer.


An alternative way to evaluate a fund manager’s performance is by looking at the risk-return relationship. The basic principle is that the returns generated should be commensurate with the level of risk taken. A fund manager who assumes higher risk should ideally generate higher returns to justify that risk, while lower returns may be reasonable if they have been achieved with lower risk. Such evaluations are made using risk-adjusted returns, for which several measures are available.

To make an informed investment decision, investors should evaluate mutual funds using a range of metrics and financial ratios. These parameters can help assess a fund’s performance, risk and suitability for their investment goals.

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Alpha: Alpha is also known as Jenson. Jenson is basically the difference between the mutual fund’s actual return and its expected performance given its level of risk as measured by beta. measures a fund’s performance relative to its benchmark index. It indicates the excess return generated by the fund manager’s skill. This ratio is used to analyze the performance of an investment manager.

A positive alpha indicates that the fund has managed to perform better than its benchmark. A positive alpha of 1.0 means the fund has outperformed its benchmark index by 1%. On the other hand, a negative alpha of 1.0 indicates the underperformance of 1% by the fund vis-à-vis its benchmark. This ratio is also interpreted as the value that a portfolio manager or the fund manager adds, above and beyond its benchmark index.

Alpha = RP – [ RF + βP (RM – RF)]

Where: RP = Expected total portfolio return, RF = Risk free return, ΒP = Beta of the portfolio, RM = Expected market return

Jensen’s alpha can be classified into two types - return due to net selectivity and return due to improper diversification.

Return due to net selectivity: Return due to net selectivity indicates the stock selection made by the fund manager. This measures the additional return generated by the fund manager’s ability to select securities that outperform the market or the fund’s benchmark index.

A positive return due to net selectivity indicates that the manager has chosen securities that have performed better than the average market performance or their sector. A negative return implies poor stock selection, meaning the chosen securities have underperformed relative to the benchmark.

Return due to improper diversification: Return due to improper diversification indicates excess returns which are generated on account of concentrated bets on stocks and sectors. In simple words, returns that are generated due to improper diversification of the portfolio.

A negative return due to improper diversification implies that the portfolio’s lack of diversification has resulted in underperformance relative to the benchmark or an equivalent diversified portfolio. A positive return due to improper diversification is rare but could occur when concentrated bets in specific securities or sectors outperform.

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Beta: Beta is a tool that is used to measure volatility or systematic risk of a mutual fund. Beta is the correlation of the fund with the market. Beta measures a fund’s sensitivity to market movements.

Ideally the beta of the market is 1.00 which means Beta measures a fund’s sensitivity to market movements. Beta of less than 1 indicates that the fund is less volatile than the market. Similarly, beta greater than 1 means the fund is more volatile than the market or benchmark.

Sharpe: The sharpe ratio tells an investor whether a portfolio's returns are due to smart investment decisions or a result of excess risk. This ratio evaluates a fund's risk-adjusted returns, indicating how much return a fund generates for the risk it takes or simply the risk premium per unit of risk.

Although one portfolio or fund can reap higher returns than its peers, it is only a good investment if those higher returns do not come with too much additional risk.

A higher Sharpe ratio suggests that the fund is delivering better returns for the level of risk undertaken, making it a critical metric for risk-conscious investors. The greater a portfolio's Sharpe ratio, the better its risk-adjusted performance has been. A negative Sharpe ratio indicates that a risk-less asset would perform better than the security being analyzed. So higher the sharpe ratio the better is the fund.

Sharpe Ratio = (RP – RF) / σP

Where: RP = Expected Portfolio Return, RF = Risk Free Rate, σP = Portfolio Standard deviation,

A variation of the Sharpe ratio is the Sortino ratio, which removes the effects of upward price movements on standard deviation to measure only return against downward price volatility.

Treynor: It is a risk-adjusted measure of return based on the systematic risk. It is considered similar to the Sharpe ratio, with the difference being that the Treynor ratio uses beta as the measurement of volatility. Higher the Treynor Ratio, the better the scheme is considered to be.

(Average Return of the Portfolio = Average Return of the Risk-Free Rate) / Beta of the Portfolio.

Information Ratio: The information ratio measures a portfolio manager's ability to generate excess returns relative to a benchmark, but also attempts to identify the consistency of the manager. This ratio will identify if a manager has beaten the benchmark. The higher the ratio the more consistent a manager is and consistency is an ideal trait.

Information Ratio = (RP – RF) / SP-I

Where: RP = Return of the Portfolio, RF = Return of the Index, SP-I = Tracking Error

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Sortino Ratio: This ratio measures the risk-adjusted return of an investment or portfolio. It is a modification of sharpe ratio that takes into account the standard deviation of negative asset returns called downside deviations. Higher the Sortino ratio higher is the return per unit of risk taken by the fund manager.

Sortino Ratio = (RP – RF) / σD

Where: RP = Return of the Portfolio, RF = Risk Free return, σD= Std dev of –ve returns

Standard Deviation: Standard deviation measures the volatility or fluctuation in a fund's returns over a given period. Funds with a high standard deviation are more volatile and may not suit risk-averse investors. A lower standard deviation indicates more stable performance.

Semi – Std Deviation: Unlike Standard deviation, which measures overall volatility in NAV, this ratio measures only downside volatility. Thus, it ignores the upside volatility which is ideal and desirable in any portfolio. The lower the value of semi std deviation, the lower is the downside potential of a fund.

R-square: The coefficient of determination also called R2 which is used to ascertain the significance of a particular beta. This measures how closely a fund’s performance correlates with its benchmark index, expressed as a percentage.

A higher R-squared (close to 100%) means the fund closely tracks the benchmark. A lower R-squared suggests more independent stock-picking by the fund manager.

How should one use these ratios for analysis?

• Set Your Goals: Define your investment objectives, risk tolerance, and time horizon.
• Compare Funds: Use the above ratios to evaluate and compare mutual funds in line with your goals.
• Seek Expert Advice: Consult with a financial advisor if you’re unsure about the implications of these ratios.
• Monitor Regularly: Regularly review your chosen fund’s performance and ensure it aligns with your expectations.

(Disclaimer: Recommendations, suggestions, views and opinions given by the experts are their own. These do not represent the views of The Economic Times)

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