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Investment Terms Explained

Common Mutual Fund Performance Measures

Assessing which mutual fund to purchase can be a difficult process for investors, as there are many factors that must be weighed before making a decision. A particular fund's past performance usually is a key factor, but of course, past performance is no guarantee of future results, especially during periods of economic turmoil. Other key factors, aside from actual portfolio returns, considered by many investors when determining which mutual fund to choose include how a fund has measured up historically against the overall market, how it has performed on a risk-adjusted basis, and how much volatility it has demonstrated. There are many standards of measurement used to assess a fund's historical record. Among those measuring sticks are the five "technical risk ratios"-statistical measurements used in modern portfolio theory.

The five technical risk ratios are as follows: alpha, beta, r-squared, standard deviation, and Sharpe ratio. We've defined these terms below and offered a brief explanation of how they can be used to assess a mutual fund's historical performance.

Alpha is a measure of a portfolio's performance on a risk-adjusted basis. Alpha takes the volatility (price risk) of a mutual fund and compares its risk-adjusted performance to a benchmark index. The excess return of the fund relative to the return of the benchmark index is known as the fund's alpha.

A positive alpha of 1.0 means the fund has outperformed its benchmark index by 1%. Correspondingly, a similar negative alpha would indicate an underperformance of 1%.

If market analysts estimate that a portfolio should earn 10% based on the risk of the portfolio, but the portfolio actually earns 15%, the portfolio's alpha would be 5.0, or 5%. This 5% is the excess return over what was predicted in the analysts' model.

Beta is a measure of the volatility, or systematic risk, of a portfolio in comparison to the market as a whole. You can think of beta as the tendency of a portfolio's returns to respond to swings in the market.

A beta of 1 indicates that the portfolio's price or return will move with the market; a beta of less than 1 means that the portfolio will be less volatile than the market. A beta of greater than 1 indicates that the portfolio's price or return will be more volatile than the market. For example, if a portfolio's beta is 1.2, it is theoretically 20% more volatile than the market.

R-squared is a statistical measure that represents the percentage of a fund's movements that can be explained by corresponding movements in its benchmark index (for example, the S&P 500).

R-squared values range from 0 to 100-an r-squared of 100 means that all movements of a portfolio are completely explained by movements in the benchmark index. A high r-squared (between 85 and 100) indicates the fund's performance patterns have been in line with a benchmark index. Conversely, a fund with a low r-squared (70 or less) has not usually acted much like the benchmark index.

A higher r-squared value will indicate a more useful beta figure. A lower r-squared value means investors probably should ignore the beta.

Standard deviation
Standard deviation is applied to the fund's annual rate of return to measure its volatility. Standard deviation is also known as "historical volatility" and is used by investors as a gauge for the amount of expected volatility. For example, a volatile portfolio will have a high standard deviation, while the deviation of a more stable portfolio will be lower. A large dispersion tells us how much the return on the fund is deviating from the expected normal returns.

Sharpe ratio
Sharpe ratio was developed by Nobel laureate William F. Sharpe to measure risk-adjusted performance. The Sharpe ratio is calculated by subtracting a risk-free rate of return, such as that of the 10-year U.S. Treasury bond, from the rate of return for a portfolio and dividing the result by the standard deviation of the portfolio's returns.

The Sharpe ratio tells us whether a portfolio's returns are due to smart investment decisions or a result of excess risk. This measurement is very useful because although one portfolio or fund can reap higher returns than its peers, it is only a good investment if those higher returns do not come with too much additional risk. The greater a portfolio's Sharpe ratio, the better its risk-adjusted performance has been. A negative Sharpe ratio indicates that a risk-free investment would perform better than the portfolio being analyzed.

"There are many standards of measurement used to assess a fund's historical record."