Mutual Fund Measurement
Mutual Fund MeasurementAccording to Merriam-Webster dictionary, a mutual fund is an open-end investment company that invests money of its shareholders in a usually diversified group of securities of other corporations. Mutual funds help with financing and investing opportunities. They give the small investors a chance to invest their money in other areas besides stocks and bonds. There are multiple mutual funds to choose from and different reasons why shareholders should choose them. There are also multiple ways to measure your portfolio’s performance. The five main indicators of investment risk are: alpha, beta, r-squared, standard deviation, and the Sharpe ratio.  Along with these five indicators, you have the Sharpe, Treynor, and Jensen methods to measure your portfolio’s performance.Alpha, is “a term commonly used to describe a manager’s abnormal rate of return, which is the difference between the return the portfolio actually produced and the expected return given its risk level” (Reilly & Brown, 2009). In other words, alpha represents “the value that a portfolio manager adds or subtracts from a fund portfolio’s return” (Loth, 2017). So, for example, if you have a positive alpha, then the fund has outperformed the benchmark index. However, if you have a negative alpha, then the fund has underperformed the benchmark index. So, you want alpha to be positive, the more positive, the better.
Beta, is “a standardized measure of systematic risk based upon an asset’s covariance with the market portfolio” (Reilly & Brown, 2009). Beta is calculated by using regression analysis. It is given that the market has a beta of 1.0. So, if you have a beta of 1.0 then the investment’s price will move with the market. If beta is less than 1.0, then the investment is less volatile than the market. Correspondingly, if beta is greater than 1.0, then the investment will be more volatile than the market. So, if you are looking to not be risky when it comes to your investments, you want to look for investments with a low beta, and vice versa. Next, is r-squared, which “is a statistical measure that represents the percentage of a fund portfolio’s or security’s movements that can be explained by movements in a benchmark index” (Loth 2017). For mutual funds, the benchmark is the U.S. Treasury Bill. R-squared has values that range from 0 to 100. So, if you have a mutual fund with an r-square between 85 and 100, then your mutual fund “has a performance record that is closely correlated to the index” (Loth 2017). Anything 70 or less would not perform like the index. So, it is suggested that mutual fund investors avoid mutual funds with high value r-squared ratios. Another indicator is standard deviation, which is “a measure of variability equal to the square root of the variance” (Reilly & Brown, 2009). In other words, the more spread apart the data is, the higher the difference is from the norm. In regards to mutual funds, the standard deviation illustrates how much the return on a fund is deviating from the expected returns based on its historical performance.So, then there are the Sharpe, Treynor, and Jensen measurements. These three sets of performance measurement tools assist in evaluating portfolios by combining risk and return performance into a single value.