PERFORMANCE MEASUREMENTS

The greater the risk of a mutual fund, the greater the possible return. But what if you want to compare funds on both risk and return?

Just looking at a fund's risk or a fund's return separately won't give you a total picture of how well a fund is doing. Luckily, we have some tools to look at that combine both elements. They measure performance that is adjusted for risk.

In our first section on monitoring mutual funds, we looked at beta. Beta shows you how volatile a fund is relative to the entire market; it is a measure of risk. If a fund has a beta of 1.1 and the overall market goes up 20 percent, you could expect the fund go up 22 percent (1.1 x 20%).

Alpha is a measure of an investment's risk-adjusted performance. Alpha compares the fund's performance to its risk using beta. If a fund's alpha is positive, it returned more than was predicted by its beta. Alpha is a way of looking at a fund's performance that includes both return and risk. It is possible that two funds with the same returns might have different alphas. The higher a fund's risk, the higher the returns it needs to produce a positive alpha. When comparing alphas of two funds having the same beta, the fund with the higher alpha is more efficient. It provides more return for the same amount of risk. Alpha is also referred to as "value added," because positive alphas let you know you have better-than-expected risk-adjusted returns.

Another way of evaluating a fund using both return and risk is the Sharpe ratio, a formula that compares the fund's performance to its risk, using standard deviation. In simple terms, standard deviation is a measure of risk that tells us how much a fund's return for each of a number of shorter periods generally varies from the fund's annual rate of return over a longer period. A high Sharpe ratio indicates that a fund is very efficient at producing higher returns for the amount of historic risk. In order to know how well your particular fund is doing, you will need to compare its Sharpe ratio with those of other funds.

Let's conclude this tutorial.