A mutual fund‘s return is often the first number investors look at. However, two funds can deliver similar returns over three or five years, yet one may have taken significantly more risk, experienced sharper swings or relied heavily on market momentum to get there.
This is why mutual fund factsheets include a range of risk and performance metrics such as standard deviation, beta, alpha, Sharpe ratio and Sortino ratio. These numbers help investors understand not just how much a fund earned, but how it earned those returns.
While they cannot predict future performance, they can offer valuable insights into how a fund has behaved in the past and how it compares with its peers. Here’s what these commonly used ratios mean and how investors can use them to make better fund comparisons.
1. Standard deviation
Imagine two mutual funds that delivered 15% annualised returns over the last three years. At first glance, they look equally good. But there is one important difference.
The first fund moved steadily higher over the period. The second saw sharp ups and downs, falling significantly during some months before recovering later. While both delivered the same return, the experience for investors was very different.
This is what standard deviation measures. It tells investors how much a fund’s returns have fluctuated around their average return over time.
A higher standard deviation means the fund’s returns have been more volatile, while a lower figure suggests a smoother journey. The number is calculated by measuring how far individual returns deviate from the average return over a period.
For investors, standard deviation is often the first indicator of risk. When comparing funds with similar returns, the one with the lower standard deviation has generally delivered those returns with less volatility.
2. Beta
Beta measures how sensitive a fund is to movements in its benchmark index. It helps investors understand whether a fund tends to rise and fall more than the market or less.
A beta of 1 means the fund broadly moves in line with its benchmark. If the market rises 10%, the fund is also expected to rise by around 10%.
A beta above 1 indicates higher sensitivity. For example, a beta of 1.2 suggests the fund may rise about 12% when the market gains 10%, but it could also fall around 12% when the market declines by the same amount.
A beta below 1 indicates that the fund is relatively less volatile than the market.
The metric is calculated by comparing the movement of a fund’s returns with those of its benchmark over time. For investors, beta is a useful way to gauge how aggressive or defensive a fund is likely to be during market swings.
3. Alpha
A fund may have delivered impressive returns, but that does not automatically mean the fund manager made great investment decisions.
Sometimes markets are so strong that simply staying invested is enough to generate good returns. Alpha tries to separate the impact of the market from the contribution of the fund manager.
In simple terms, alpha measures how much a fund outperformed or underperformed after accounting for the level of risk it took.
Suppose two funds have similar exposure to the market and take comparable levels of risk. If one fund delivers higher returns, it is likely to have a higher alpha.
A positive alpha suggests the fund delivered more than its risk profile would have predicted. A negative alpha indicates that the fund failed to adequately reward investors for the risk it took.
For investors, alpha is often viewed as a measure of a fund manager’s ability to create value beyond simply riding a rising market.
4. Sharpe ratio
Imagine two funds delivered identical returns of 15%. If one achieved that return with significantly lower volatility, most investors would consider it the superior fund. The Sharpe ratio helps identify such cases.
The ratio measures how much excess return a fund has generated for each unit of risk taken. Rather than focusing solely on returns, it evaluates how efficiently those returns were produced.
The ratio is calculated by dividing the fund’s excess return over the risk-free rate by its standard deviation. A higher Sharpe ratio generally indicates that investors were rewarded more generously for the volatility they endured.
This makes the metric particularly useful when comparing funds within the same category that have similar return profiles.
5. Sortino ratio
Not all volatility is undesirable. Most investors do not mind upside surprises. What concerns them is the risk of losses.
The Sortino ratio addresses this by considering only downside volatility rather than total volatility. It tells investors how much return a fund generates for every unit of downside risk taken.
As a result, it provides a clearer picture of how effectively a fund has generated returns relative to the risk of negative outcomes. A higher Sortino ratio suggests that a fund has been more effective at rewarding investors without exposing them to excessive downside risk.
The takeaway?
No single ratio can determine whether a mutual fund is good or bad. Standard deviation helps measure volatility, beta shows market sensitivity, alpha evaluates manager skill, while Sharpe and Sortino ratios assess risk-adjusted returns.
Used together, these metrics can help investors look beyond headline returns and make more informed comparisons between funds in the same category.