Tuesday, April 1, 2008

Is it right to compare only the returns of the fund with the benchmark?

No. as we have seen earlier, returns have to be studied along with the risk. This means, a fund could have earned higher return than the benchmark. But such higher return may be accompanied by higher risk. Therefore, we have to compare funds with the benchmarks, on a risk-adjusted basis. In order to do this, we compute the return and risk for both the fund and the benchmark, and find out what is the return per unit of risk, earned by each of them. For example, over the same period of a1 year, the risk and return are as follows:
Benchmark:
Return: 12%
Risk (Standard deviation) = 9%
Fund:
Return: 16%
Risk: 11%
We find that the fund has outperformed the be4nchmark in terms of the return that it has earned. However, we also notice that the return is accompanied by a higher level of risk. We can then compute return per unit of risk as follow:
Benchmark: 12/9
Return per unit of risk: 12/9 = 1.33
Fund 16/11
Return per unit of risk: 16/11 = 1.45
We find that the return per unit of risk for the fund is higher. This means that on a risk-adjusted basis, the fund has performed better than the market.

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