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Aroutine health check is good for both an investor and his/her investments. It helps to understand where one is and where the individual seems to be heading: both health and investmentwise. In this article, we present some of the tools which can help you assess the performance of your equity mutual fund investments.
There are several ratios which are indicative of the performance of your investment. We have covered three of them: the Sharpe Ratio and the Upside and Downside Capture ratios earlier. In this article, we will cover three more such tools: Standard Deviation, Treynor Ratio and Information Ratio.
Standard Deviation
Standard Deviation (SD) measures the dispersion of a set of data from its mean, that is a measure of the average of the data. The higher the SD, the more is the data away from the mean and vice-versa. Simply put, this statistical measure represents the volatility or risk of an instrument. As the SD increases, so does the risk, which means that your investment has a chance to move either up or down in a much wider band than an instrument with a low SD. For instance, if an equity fund has given 15% return on an average with an SD of 20 percentage points, its range of return can vary from -5% to 35%.
A high SD is not necessarily bad though, given the risktaking capacity of an individual. Our readers will recall that SD is used in the denominator while calculating the Sharpe Ratio. So if your equity fund can consistently provide a high Sharpe Ratio for long periods even after having a high SD, it means that it is rewarding you well for the additional risk taken.
A related measure of deviation in the performance of especially indes funds and exchange-traded funds (ETFs) is the tracking error (TE). This measure can single-handedly determine whether your index fund or ETF has done its job well or not. TE is the deviation between the returns of an instrument and the benchmark that it intends to replicate. Index funds and ETFs necessarily report a TE because of the expenses incurred in tracking their benchmark. But their efficiency in managing these expenses is shown by the TE. The thumb rule is that lower the TE, the better the fund is.
Treynor Ratio
Named after Jack L Treynor, this ratio is similar to the Sharpe Ratio in that it also measures the excess returns provided by an instrument over a risk-free rate. But unlike Sharpe Ratio, which uses total risk (SD), Treynor Ratio uses market risk, represented by beta, in the denominator. Due to the use of beta in the calculation, this ratio is also known as reward-to-volatility ratio, since beta is the measurement of a security's sensitivity to market movements (represented by a benchmark, which could be the sensex or the nifty for equities). As with the Sharpe Ratio, the higher the Treynor Ratio, the better it is for you.
Information Ratio
Information Ratio (IR) is calculated by dividing the active return (returns of an instrument over a benchmark) by the volatility of those returns represented by TE. The IR can test the consistency of a fund manager as it determines whether he/she has beaten the benchmark by a large margin in a few months or by small margins every month. For a given level of risk taken, a higher active return will result in a higher IR, which in turn proves the consistency of a manager in delivering superior returns.
Apart from the ratios given above, another popular measure is the Sortino Ratio, which takes the difference between actual returns of a managed instrument and the required rate of return and divides it by downside deviation (SD of returns below the required or target return).
Jensen's Alpha, which determines the abnormal return of a fund over the theoretical expected return, is also popular.
However, irrespective of the tool you use for evaluation, the bottom line remains the same: Any health check makes use of several tools and tests, not just a few, and being a diligent investor, so should you.
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