Risk and Return Tradeoff in Context of Mutual Funds

Like all the other investment avenues, mutual funds too have investment risk. It is very important to maintain risk and return tradeoff when investing into mutual funds and calculating the returns. It is true that the risks on investments into the mutual funds are lower than the investment into the stocks directly. Because of this reason many investors tend to ignore the risk component while calculating the effective returns from the mutual funds.

Risk

Risk is a factor that often is ignored by the investors while they are evaluating the returns of a mutual fund scheme. In a bull market a fund might yield the best of returns by following an aggressive investment strategy, but in times of bear market the fund could end up losing it all the value it gained during the bull market. This behavior of the funds is very important and significant. This simply means that the returns from the funds could be highly volatile. This volatility can be very harmful for the common investors. It is not possible that there remains no risk with the investments into the mutual funds but this should remained understated the financial goals of the investor. This is the reason why investors are suggested to take care of the risk and return tradeoff. The higher the fluctuations in the returns of a fund during a given period, higher will be the risk associated with it.

Types of Risk

Fluctuations in the returns generated by a fund are resultant of two guiding forces. First, general market fluctuations, which affect all the securities present in the market. This is known as the market risk or systematic risk. Systematic risk is also known as the un-diversifiable risk. The second type of risk is the fluctuations due to specific securities present in the portfolio of the fund, called unsystematic risk or the diversifiable risk. The Total Risk of a given fund is the sum of these two and is measured in terms of standard deviation of returns of the fund.

Systematic risk is measured in terms of Beta, which represents fluctuations in the NAV of the fund vis-à-vis the market. Beta is calculated by relating the returns on a mutual fund with the returns in the market. The more responsive the NAV of a mutual fund is to the changes in the market, the higher will be its Beta. Diversification through investments in a number of instruments can limit unsystematic risk, but market risk, i.e., the influence of economy-related factors like fiscal policy, industrial policy, money supply, and inflation, cannot be eliminated.

The most important and widely used measures of performance using risk adjusted returns are:-

  • Treynor Ratio
  • Sharpe Ratio
  • Jenson Model
  • Fama Model

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