Assuming no material change in the fund and/or underlying holdings’ characteristics, one can assume that Fund 1 will likely be a more volatile investment than Fund 2. In debt funds, Gilt funds and Income funds have higher volatility (by extension, higher standard deviation) than Liquid funds. In other words, it is a measure of how much deviation occurs from the expected return of the instrument in question. The words volatility and standard deviation are used interchangeably. The higher the standard deviation, the greater the fluctuation is.
Because if S&P Sensex 500 falls by 1%, then Tata Multicap fund is expected to fall by only 0.65% and not 0.95%. One of the key attributes of the mutual fund is the ‘beta’ of the fund. The beta of a mutual fund is the measure of relative risk, expressed as number; Beta can take any value above or below zero. Beta gives us a perspective of the relative risk of the mutual fund vis a vis its benchmark.
- In these charts, normally narrow Bollinger bands suddenly bubble out to accommodate the spike in activity.
- If you’ve done extensive research when analyzing mutual funds, you may have run across a statistical analysis term called standard deviation (not to be confused with downside deviation).
- Similarly 95% of the time the future returns are likely to fall between 4% and 16% (10% average plus or minus twice the standard deviation i.e. 6).
- This means that returns that are above average will increase the SD the same way as returns that are below the average.
This deviation is a crucial ratio typically utilised by fund managers that benefit investors. To better assist you in evaluating risk, let’s explore the standard deviation. This deviation makes sense when comparing funds from the same category and asset class. The comparison will have greater meaning if the time period is likewise the same.
Importance of Standard Deviation in Mutual Funds
Alternatively, you can estimate with 95% certainty that annual returns do not exceed the range created within two standard deviations of the mean. Markets are volatile, and equities are volatile, mutual funds are volatile; this is the very nature of markets. So if you can’t fathom watching your investment see-saw between gains and loss, then perhaps you should reconsider your investment decision in equities. Now, if the beta of a mutual fund is equal to 1, then what is standard deviation in mutual fund it means the fund is as risky as its benchmark.
What is the 15*15*15 Rule in Mutual Funds & Why Should Invest in It?
Variance stands for the average of the squared differences about the mean. The variance can be calculated by getting the difference of each point from the mean. In other words, standard deviation measures how to spread out each data point from the mean. A standard deviation is a number (expressed as a percentage) that can be used to show how much the returns of a mutual fund scheme are likely to deviate from its average annual returns.
While choosing a fund going by the standard deviation definition you may use standard deviation as a measure of risk assessment in alignment with your own risk appetite and investment time frame. For example if fund A’s risk appetite is higher than fund B’s choose the one that is in agreement with your risk appetite. The SD of India domiciled mutual funds is computed based on the monthly returns for the past 3 years (as prescribed by AMFI) using the above denoted formula. Simply averaging out the standard deviations, is no answer to understanding the market volatility of the portfolio.
One of the reasons for the widespread popularity of the standard deviation measurement is its consistency. Standard deviation is calculated by taking the square root of the variance, which itself is the average of the squared differences of the mean. In this case, Fund B is a better choice because Fund B generates more return for every unit of risk undertaken. So it turns out that both the funds are similar in terms of their risk and reward perspective. I guess it gets a little complex to figure out which these two funds are better given that we have to evaluate them on two parameters, i.e. both the risk and return. Give your investments time, and time will take care of volatility.
It is used to measure the distribution of the actual return from the mutual fund’s expected annual return. The square of each of these numbers must be added and the result must be divided by the total number of data points minus 1. Volatility refers to the extent to which a fund’s net asset value (NAV) fluctuates over a period of time.
Furthermore, all the monthly standard deviation values are annualised and represented as a percentage. For a mutual fund, it shows how far the returns deviate from the expected returns based on its past performance. From an asset class lens, equity exhibits higher volatility than fixed-income and commodities, albeit the potential upside too is higher. Well-diversified portfolios reduce the portfolio risk as they invest into diverse asset-classes/securities which respond differently to the same set of economic drivers. This cushions the portfolio against the underperformance of some of its constituents and provides a stable investment journey for the investor. Beta, on the other hand, is used to quantify the fund’s response to market volatility.
Use of Standard Deviation in Mutual Funds
It is usually measured by calculating the average difference between the highest and lowest price of the asset. It does not mean anything unless compared to funds in the peer group. As explained above a greater standard deviation in a fund indicates greater volatility. In other words, returns of funds with a high standard deviation may fluctuate either on the higher or lower side of the average and may be said to lack consistency. By measuring the standard deviation of a portfolio’s annual rate of return, analysts can see how consistent the returns are over time.
Mutual Fund Beta, SD, and Sharpe Ratio
This can be mapped to your own risk appetite in order to decide if a fund works for you or not. As you can see in the table below, the Standard Deviation of equity funds is higher as compared to debt funds. Within debt funds, the SD of Liquid Fund will be lower in comparison to Dynamic Bond Fund which takes duration bet, or Gilt Fund which is susceptible to interest rate risk. To conclude, alpha is the excess return of the fund over above the benchmark returns.
2 – Alpha
Hence looking at these ratios in conjunction with each other provides you with a broader picture and helps you make a more informed decision. The more securities held in a portfolio, and the more variety of types of securities, the less each individual security and its standard deviation matter to the whole portfolio. Now, instead of 34% standard deviation, assume Fund B’s standard Deviation is 18%. It bundles the concept of risk, reward, and the risk-free rate and gives us a perspective. Well, Fund B has a higher return, so without a doubt, Fund B is a better fund.