Measuring and Managing Risk in Mutual Fund Schemes
Types of risk
Systematic (market) risk affects the whole market and cannot be diversified away: equity price risk, interest-rate risk, currency risk, inflation risk, political risk. Unsystematic risk is security- or issuer-specific - credit risk, business risk, liquidity risk, concentration risk - and can be reduced by diversification.
Two further debt-specific concepts: interest-rate risk rises with duration (longer duration, higher price sensitivity to rate changes), while credit risk is captured by rating and by the fund's exposure to lower-rated paper. Reinvestment risk matters for interest payouts.
The measurement toolkit
- Standard deviation - total volatility of returns.
- Beta - sensitivity to the market; beta above 1 means more volatile than the index.
- Sharpe ratio = (Rp − Rf) ÷ σp - excess return per unit of total risk.
- Treynor ratio = (Rp − Rf) ÷ β - excess return per unit of systematic risk.
- Jensen's alpha = Rp − [Rf + β(Rm − Rf)] - return unexplained by market exposure.
- Sortino ratio - like Sharpe but penalises only downside deviation.
- Tracking error - standard deviation of the fund-minus-benchmark return; information ratio = active return ÷ tracking error.
- Maximum drawdown - worst peak-to-trough fall.
Traps
Sharpe uses total risk, Treynor uses beta - the commonest swap in exams. A negative Sharpe ratio is not meaningful. Beta measures volatility relative to the market, not the quality of the fund. A high-yield debt fund is not "safer" than a gilt fund.
Worked example: Rp = 14%, Rf = 6%, σ = 10%, β = 1.2. Sharpe = (14−6)/10 = 0.80; Treynor = 8/1.2 = 6.67.