Mutual Funds: Data Definitions: Ratings and Risk

When considering a fund’s volatility, an investor may find it difficult to decide which fund will provide the optimal risk-reward combination. Many websites provide various volatility measures for mutual funds free of charge; however, it can be hard to know not only what the figures mean but also how to analyze them. If the beta of a mutual fund is less than 1, then the fund is perceived as less risky compared to its benchmark.

1. Standard deviation is a statistical measurement that shows how much variation there is from the arithmetic mean (simple average).
2. This is consistent with the CSA’s criteria and key objectives of the Initial 2013 Proposal to achieve a uniform methodology applicable to all investment funds, and to be meaningful and allow for easy comparison across investment funds.
3. If the investor is risk-loving and is comfortable with investing in higher-risk, higher-return securities and can tolerate a higher standard deviation, he/she may consider adding in some small-cap stocks or high-yield bonds.
4. When a security has experienced a period of great volatility, the bands are wide apart.
5. One of the key attributes of the mutual fund is the ‘beta’ of the fund.
6. A higher standard deviation indicates more variability or risk, whereas a lower standard deviation suggests less variability around the mean.
7. Once expected returns of a portfolio reach a certain level, an investor must take on a large amount of volatility for a small increase in return.

Optimal Portfolio Theory and Mutual Funds

First, the average monthly return of the 90-day Treasury bill (over a 36-month period) is subtracted from the fund’s average monthly return. The difference in total return represents the fund’s excess return beyond that of the 90-day Treasury bill, a risk-free investment. An arithmetic annualized excess return is then calculated by multiplying this monthly return by 12. To show a relationship between excess return and risk, this number is then divided by the standard deviation of the fund’s annualized excess returns.

How to find the different mutual fund ratios in StockEdge?

1. The essence of standard deviation lies in its ability to measure risk.
2. The number tells us that the fund generates 0.29 units of return (over and above the risk-free return) for every unit of risk undertaken.
3. Standard deviation is the statistical measurement of dispersion about an average, which depicts how widely a stock or portfolio’s returns varied over a certain period of time.
4. In each Morningstar Category, the top 10% of funds earn a High Morningstar Return, the next 22.5% Above Average, the middle 35% Average, the next 22.5% Below Average, and the bottom 10% Low.

Accordingly, a fund with a 1.10 beta has performed 10% better than its benchmark index–after deducting the T-bill rate–than the index in up markets and 10% worse in down markets, assuming all other factors remain constant. Conversely, a beta of 0.85 indicates that the fund has performed 15% worse than the index in up markets and 15% better in down markets. A low beta does not imply that the fund has a low level of volatility, though; rather, a low beta means only that the funds market-related risk is low. Thus, though the specialty fund might fluctuate wildly because of rapid changes in gold prices, its beta relative to the S&P may remain low. The Initial 2013 Proposal set out a process for monitoring risk categorizations on a monthly basis.

According to the modern portfolio theory, funds lying on the curve are yielding the maximum return possible, given the amount of volatility. Though the standard deviation is an important measurement for mutual fund-related investment decisions, still like every other metric, standard deviation also has certain limitations. To conclude, alpha is the excess return of the fund over above the benchmark returns. The fund is rewarded if the returns are generated by keeping a low-risk profile and penalized for being volatile. Alpha is defined as the excess return of the mutual fund over the benchmark return, on a risk-adjusted basis.

Average

If the standard deviation is high, the returns are more spread out and risky. This way, investors can know if they’re taking a lot of risk or playing it safe. This gives you the standard deviation, showing how much the returns vary from the average.

The risk-free return is the maximum return you can generate without taking any risk. By risk I mean – market risk, credit risk, interest rate risk, and unsystematic risk. If the beta was 0.6 or 0.65, the fund is less risk or less volatile compared to its benchmark.

Other Data to Consider

An assessment of the variations in a fund’s monthly returns, with an emphasis on downside variations, in comparison to similar funds. In each Morningstar Category, the 10% of funds with the lowest measured risk are described as Low Risk, the next 22.5% Below Average, the middle 35% Average, the next 22.5% Above Average, and the top 10% High. Morningstar Risk is measured for up to three time periods (three-, five-, and 10-years). These separate measures are then weighted and averaged to produce an overall measure for the fund. Funds with less than three years of performance history are not rated. While standard deviation determines the volatility of a fund according to the disparity of its returns over a period of time, beta, another useful statistical measure, compares the volatility (or risk) of a fund to its index or benchmark.

First, we calculate the mean (average) annual return of the fund over these 5 years. In this case, Stock A is considered less volatile than the market as its beta of 0.611 indicates that the stock experiences 39% less volatility than the Index ABC. In this case, Stock X is considered more volatile than the market as its beta of 1.69 indicates that the stock experiences 69% more volatility than the Index XYZ.

A normal standard deviation for a portfolio varies based on the type of investments. There’s no exact number, so it’s important to compare it with similar portfolios to see if it’s normal. Up to this point, we have learned how to examine figures measuring risk posed by volatility, but how do we measure the extra return rewarded to you for taking on the risk posed by factors other than market volatility? Enter alpha, which measures how much if any of this extra risk helped the fund outperform its corresponding benchmark. Using beta, alpha’s computation compares the fund’s performance to that of the benchmark’s risk-adjusted returns and establishes if the fund outperformed the market, given the same amount of risk.

Alternatively, you can estimate with 95% certainty that annual returns do not exceed the range created within two standard deviations of the mean. If the returns for a stock or portfolio follow a normal distribution, then approximately 68 percent of the time they will fall within one standard deviation of the mean return, and 95 percent of the time within two standard deviations. For example, if the mean annual return is 10 percent and the standard deviation is 2 percent, you would expect the return to be between 8 and 12 percent about 68 percent of the time, and between 6 and 14 percent about 95 percent of the time.

Morningstar rates mutual funds from one to five stars based on how well they’ve performed (after adjusting for risk and accounting for sales charges) in comparison to similar funds. Within each Morningstar Category, the top 10% of funds receive five stars and the bottom 10% receive one star. Funds are rated for up to three time periods—three-, five-, and 10 years—and these ratings are combined to produce an overall rating. Ratings are objective, based entirely on a mathematical evaluation of past performance.

The objective is to optimize expected returns against a certain level of risk taken. Assets that have a low correlation to each other helps in reducing the amount of overall risk for a portfolio. To obtain the best-fit index, Morningstar regresses the fund’s monthly excess returns against monthly excess returns of several well-known market indexes. For Alpha vs. the Standard Index, Morningstar performs its calculations using the S&P 500 as the benchmark index for equity funds and the Barclays Aggregate as the benchmark index for bond funds. Morningstar deducts the current return of the 90-day T-bill from the total return of both the fund and the benchmark index. The exact mathematical definition of alpha that what is standard deviation in mutual fund Morningstar uses is listed below.

Firstly, standard deviation measures the dispersion of data points around the mean, indicating the degree of variability within a dataset. A smaller standard deviation suggests that the data points are clustered closely to the mean, indicating lower volatility, while a larger standard deviation indicates greater variability and risk. In portfolio construction, standard deviation aids in identifying the right balance between risk and return. For example, a portfolio heavily weighted in high-standard deviation assets may offer higher returns but also exposes investors to significant volatility.