When it comes to mutual fund research, many investment tools use concepts such as beta, sharpe ratio and standard deviation as measurements of risk. Jemstep offers explanations of these and other complex measurements so that individual investors of all levels can educate themselves whilst interacting with Jemstep’s website. Here are explanations of some widely used risk measurements you are likely to see on a mutual fund’s prospectus or monthly reports:

Beta

Volatility to an index. Funds with higher betas imply greater volatility.

Beta is a measure of a fund’s volatility relative to a market index, over a given period. For your own mutual fund research, you should know that funds with higher betas imply greater volatility, and are considered to carry a higher risk. Investors may be willing to accept a higher level of risk as it may pay off in the form of higher returns. A beta of 0.75 means the fund has been 25% less volatile than the index. A beta of 1.0 implies the fund’s volatility has been equal to the index. If the index increases by 5% the fund will, in all likelihood also increase by 5%. The fund’s returns correlate with the index. A beta of 1.25 means the fund has been 25% more volatile than the index. A beta of 2.0 means the fund has been 100% more volatile than the index. If the index increases by 5% the fund will, in all likelihood increase by 10%. A beta of 0.0 does not mean that the fund is risk free. It simply means that there is no correlation between the fund and the index. A negative beta means the fund’s returns move in an opposite direction to the index. When you compare mutual funds, look for a lower beta if you’re seeking less risk.

Sharpe Ratio

Risk-adjusted performance. A higher Sharpe ratio means a higher return was achieved with less risk.

The Sharpe ratio is a measure of reward per unit of risk (risk-adjusted performance). A higher Sharpe ratio means the fund’s management achieved a higher return whilst taking on less risk (management made smart investment decisions). The Sharpe ratio is calculated by subtracting the risk free rate (the 10-year U.S. Treasury bond rate) from the fund’s return and then dividing the result by the standard deviation (a measure of risk – see below). Complex? Yes, but for the purposes of your own mutual fund research, simply remember that a higher Sharpe ratio is preferable.

Standard deviation

Historic volatility. A higher standard deviation implies greater volatility.

Standard deviation measures the dispersion of a fund’s returns from the average (mean) for a given period. In your mutual fund analysis, a higher standard deviation means the fund’s range of performance has been wide – this indicates a greater potential for future uncertainty (or higher risk).

Users needn’t understand these concepts to use Jemstep. In fact, we try avoid complex jargon where possible. However, when conducting your own mutual fund research, knowing the essence of what these concepts mean could prove useful.