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A risk-adjusted return is the return, or potential return, of an investment calculated by considering the level of risk that must be accepted in order to achieve it. Risk-adjusted asset management is measured relative to substantially risk-free assets.
Depending on the method used, risk calculations are expressed as numbers or ratings. Risk-adjusted returns apply to individual stocks, mutual funds and entire portfolios. Understanding risk-adjusted returns measures the return an investment makes relative to the amount of risk the investment represents over a period of time. When two or more investments produce the same return over a period of time, the investment with the lowest risk will have the highest risk-adjusted return.
The Sharpe ratio measures the return on investment over the risk-free rate per unit standard deviation. It is calculated by subtracting the risk-free rate from the return on investment and dividing the result by the standard deviation of the investment. If all other things being equal, a higher Sharpe ratio is better.
Let’s understand this from a decent mutual fund distributor perspective, Mutual Fund A had a 12% return with a 10% standard deviation over the past year, and Mutual Fund B had a 10% return with a 7% standard deviation and a risk-free rate of 3% during the period. The Sharpe ratio is calculated as:
Mutual Fund A:
(12% – 3%) / 10% = 0.9
Mutual Fund B:
(10% – 3%) / 7% = 1
Mutual Fund A had a higher return, while Mutual Fund B had a higher risk-adjusted return, resulting in a higher return per unit of total risk than Mutual Fund A.
The Treynor ratio is calculated in the same way as the Sharpe ratio, but uses the investment’s beta as the denominator. As is the case with the Sharpe, a higher Treynor ratio is better.
Using the previous fund example and assuming a beta of 0.75 for each fund, the calculation would be:
Mutual Fund A:
(12% – 3%) / 0.75 = 0.12
Mutual Fund B:
(10% – 3%) / 0.75 = 0.09
Here, Mutual Fund A has a higher Treynor ratio, which means it has a higher return per unit of systematic risk than Fund B.
Risk aversion is not always a good thing when it comes to investing. So be careful not to overreact to these numbers, especially if the timeframe you are measuring is short. In a strong market, a mutual fund that carries less risk than its benchmark when you will invest under our guidance.
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