Mutual Fund Risk

Statistics that measure mutual fund risk are crucial to the process of screening mutual funds. Investors need to know how risky individual assets are and what their contribution to the total risk of a portfolio would be.

I won't go into detail on the standard deviation of returns, as it's covered thoroughly in Mean & Standard Deviation, Investment Risk and Risk & Return. Suffice it to say that the standard deviation is an important statistic that measures risk in terms of variability, and in investing, variability is the standard measure of investment risk. This applies not only to individual securities, but to mutual fund risk as well.

The standard deviation of mutual fund returns is a measure of total risk, i.e., specific and systematic risk. However, the standard deviation of a well-diversified portfolio is both the total risk and residual risk, as 100% of the specific risk has presumably been diversified away.

Beta, a.k.a. market risk or systematic risk, is another measure of risk that is covered in depth elsewhere on this site. See Market Risk and Risk & Return.

Beta measures mutual fund risk relative to a benchmark, usually the S&P 500, and is a measure of systematic risk rather than total risk. Like standard deviation, beta is a measure of variability but it's variability is relative to the benchmark rather than a fund's own mean. Beta will give you a good idea of how much a fund is likely to move with movements of the benchmark.

As beta is a measure of systematic risk, a portfolio's beta is simply the weighted average of the betas of the assets held in the portfolio, thus providing a measure of the systematic risk of the portfolio. As noted above, in a well-diversified portfolio, total risk is equal to systematic risk, as the specific risk has presumably been diversified away.

The R-squared statistic should be reported along with beta. R-squared is one of the statistics generated by the regression analysis used to derive a mutual fund's beta. It is the coefficient of determination, which tells you what percent of the movement in the fund is explained by movement in the benchmark used in the regression analysis. The S&P 500 is the benchmark most commonly used for this purpose. The higher the R-squared, the more reliable beta is as a measure of probable variation.

R-squared is also the square of the correlation coefficient, as such it will give you some idea of the degree of correlation between a fund and the benchmark but, as the square root of a number is an absolute value, you won't know whether R is positive or negative. It also won't tell you how a fund behaves relative to other funds in your portfolio. But R-squared is still useful for screening, as low values indicate that a fund may have good diversification potential and therefore warrants a closer look.

Bond Duration is the standard measure of a bond's sensitivity to changes in interest rates. In general, the longer the duration, the higher the sensitivity.

Interest rate sensitivity is the basis for a portion of the risk premium investors assign to bonds. The average duration of a bond mutual fund's holdings determines its overall sensitivity to fluctuations in interest rates and is the measure of the level of interest rate risk you are exposed to by holding the fund.

A bond's duration is the weighted average time to maturity based on the present value of the cash flow expected from the bond discounted at the bond's current yield to maturity. The average duration of a bond mutual fund is simply the weighted average of the durations of the bonds in the fund's portfolio.

The following is an example of the computation of a bond's duration:

Tabulation and Computation of Bond Duration



In this example, the bond's duration of 4.38 years would place it in the lower end of the Intermediate range of duration or interest rate sensitivity, depending of whose style box you are looking at.

That's mutual fund risk in a nutshell. As I noted above, all of these statistics are addressed in detail elsewhere on this site.