The Money Today readers never cease to surprise us with their thirst for knowledge. When we carried “Four Ratios to Know ”, it was to inform you about the tools that fund managers use. We expected to receive a few responses from readers saying it was too complicated and could we address the lay investors, please. We did get those reactions—but they were in a minority.
Most of you wanted to know more, with some writing in to ask for the actual formulae, others for real-life examples. Before we do that, let us remind you that these ratios are tools not meant for small investors.
Use them if you must, but consider them a general guide more than a to-scale map. For those who came in late, we’ll run you through the ratios before getting to the meat—the actual calculations. The Sharpe and Treynor ratios evaluate the surplus that a fund earns over the risk-free fixed returns, taking stock market volatility into account.
The Sortino ratio is similar to Sharpe, except that it uses downside deviation for the denominator instead of standard deviation (which doesn’t make a distinction between upward and downward volatility). Jensen’s Alpha helps calculate the value by which the fund has beaten its benchmark and the risk taken by the fund manager.
Here’s how these ratios can be put to practical use. We have used all four to analyse the HDFC Equity Fund, one of India’s oldest and most popular equity diversified funds.
— Sameer Bhardwaj
Applying ratios to HDFC Equity Fund | ||
| Specific responses have been e-mailed to the dozens of readers who responded to our cover story on mutual funds asking for more information. Here we explain the four ratios in detail, using the example of an actual equity diversified mutual fund scheme. | ||
| Risk-free returns: Returns offered by govt securities like treasury bills.We have assumed 6% p.a. risk-free rate, which is 0.5% per month | 0.50% | |
| Average returns: Average monthly returns from the fund schemes in the past three years | 2.77% | |
| Average returns: Average monthly returns from CNX 500 index, which is the benchmark for this fund | 2.57% | |
| Standard deviation: A measure of total risk (market risk plus company-specific risk).The higher the SD, the higher the total risk | 5.83% | |
| Beta: Shows sensitivity of the fund with respect to its benchmark (CNX 500).The value of 0.87 implies that for every 10% rise or fall in CNX 500, the fund’s return on an average will rise or fall by 8.7% | 0.87 | |
| Downside standard deviation: Measures only downside volatility, unlike the SD that captures both upside and downside volatility | 3.82% | |
| CAPM returns (risk-free returns) + beta x market returns minus risk-free returns: Capital Asset Pricing Model states that securities with higher market risk (beta) should command a higher premium than risk-free rate | 2.29% | |
| Ratios | Formula | Value |
| Sharpe | (Average fund returns minus risk-free returns) divided by standard deviation | 0.390 |
| For every unit of total risk, the HDFC Equity Fund is returning an excess of 0.39 | ||
| Treynor | (Average fund returns minus risk-free returns) divided by beta | 0.026 |
| For every unit of market risk, the fund is returning an excess of 0.026 | ||
| Alpha | Average fund returns minus CAPM returns | 0.005 |
| Positive alpha means that over the past 3 years, on an average, the fund manager has performed better than the market | ||
| Sortino | (Average fund returns minus risk-free returns) divided by downside SD | 0.594 |
| High ratio indicates low risk of loss. Sortino of 0.594 implies that for every unit of downside standard deviation, the fund is returning an excess of 0.594 | ||
| For Sortino ratio, the minimum acceptable returns are assumed to be 0% | ||
| Notes: Beta is a covariance of fund and benchmark returns divided by variance of benchmark returns. It is also calculated by simple regression of fund returns and benchmark returns.The coefficient of benchmark is the beta value. If you still feel out of depth with these figures, you might want to check out the following links.The best place to start is www.investopedia.com, but for details try www.valueresearchonline.com or www.myplexus.com. If you still have questions, e-mail them to sameer.bhardwaj@intoday.com. | ||
