One of the principles of investing is the risk-return tradeoff, defined as the correlation between the level of risk and the level of potential return on an investment. For the majority of stocks, bonds and mutual funds, investors know accepting a higher degree of risk or volatility results in a greater potential for higher returns. To determine the risk-return tradeoff of a specific mutual fund, investors analyze the investment's alpha, beta, standard deviation and Sharpe ratio. Each of these metrics is typically made available by the mutual fund company offering the investment.
Mutual Fund Alpha
Alpha is used as a measurement of a mutual fund's return in comparison to a particular benchmark, adjusted for risk. For most equity mutual funds, the benchmark used to calculate alpha is the S&P 500, and any amount of the risk-adjusted return of a fund above the benchmark's performance is considered its alpha. A positive alpha of 1 means the fund has outperformed the benchmark by 1%, while a negative alpha means the fund has underperformed. The higher the alpha, the greater the potential return with that specific mutual fund.
Mutual Fund Beta
Another measure of risk-reward tradeoff is a mutual fund's beta. This metric calculates volatility through price movement compared to a market index, such as the S&P 500. A mutual fund with a beta of 1 means its underlying investments move in line with the comparison benchmark. A beta that is above 1 results in an investment that has more volatility than the benchmark, while a negative beta means the mutual fund may have fewer fluctuations over time. Conservative investors prefer lower betas and are often willing to accept lower returns in exchange for less volatility. (For related reading, see "Alpha and Beta for Beginners.")
In addition to alpha and beta, a mutual fund company provides investors with a fund's standard deviation calculation to show its volatility and risk-reward tradeoff. Standard deviation measures an investment's individual return over time and compares it to the fund's average return over the same period. This calculation is most often completed using the closing price of the fund each day over a set period of time, such as one month or a single quarter.
When daily individual returns regularly deviate from the fund's average return over that timeframe, the standard deviation is considered high. For example, a mutual fund with a standard deviation of 17.5 has higher volatility and greater risk than a mutual fund with a standard deviation of 11. Often, this measurement is compared to funds with similar investment objectives to determine which has the potential for greater fluctuations over time.
A mutual fund's risk-reward tradeoff can also be measured through its Sharpe ratio. This calculation compares a fund's return to the performance of a risk-free investment, most commonly the three-month U.S. Treasury bill (T-bill). A greater level of risk should result in higher returns over time, so a ratio of greater than 1 depicts a return that is greater than expected for the level of risk assumed. Similarly, a ratio of 1 means a mutual fund's performance is relative to its risk, while a ratio of less than 1 indicates the return was not justified by the amount of risk taken.
(For related reading, see "Financial Concepts: The Risk/Return Tradeoff.")