What is Alpha in Mutual Funds?
Alpha is the excess return delivered by a mutual fund over its benchmark after adjusting for risk. The “after adjusting for risk” part of the sentence is extremely important.
In finance, it is very much possible to generate a high return by taking a high risk. Hence, the concept of alpha says that when assessing a mutual fund, you should not focus only on how much extra returns it has generated over its benchmark. Rather, you should also consider the risk taken by a fund to generate that extra return.
Let us say that a mutual fund has provided a return of 12% over the last 3 years; however, its benchmark provided only 9% returns in the same period. Suppose the fund’s beta is 0.8 and the risk-free rate is 4%.
Now, we will use the capital asset pricing model (CAPM) to calculate the expected return from the fund. As per the CAPM model, the expected return can be estimated using the following equation:
Expected Return = Risk free Rate + Beta * (Benchmark Return – Risk Free Rate)
Expected Return for our example = 4% + 0.8 * (9% – 4%) = 8%
Hence, the expected return for our example is 8%. Alpha is the excess return of a fund over its expected return. So, Alpha equals 4% (12% - 8%). Now that you know what alpha is in mutual funds, let us delve deeper into this topic.
Key points to remember about Alpha in Mutual Funds
When it comes to Alpha, you should remember the following important points:
Alpha means the excess returns generated by a fund above its benchmark when adjusted for risk.
It shows the value added or lost by a mutual fund manager. Hence, it is an extremely important indicator.
When calculating alpha for a mutual fund, we should select an appropriate benchmark. For example, if a fund invests in large-cap pharma stocks, we should not consider Nifty 50 as the benchmark because Nifty 50 is a much wider index. For such a fund, we should consider the Nifty Pharma Index.
What is BETA in Mutual Funds?
A mutual fund’s Beta shows its volatility in relation to its benchmark index. The Beta of a benchmark index is always assumed to be 1. If a mutual fund’s Beta is 1, it means the fund provides exactly the same returns as its benchmark index. Hence, if the index moves up 10%, the fund will provide a 10% return. But, if the index moves down by 5%, the fund too will lose 5% of its value.
Let us say that a mutual fund’s beta is 1.5. In this case, if its benchmark index moves up by 10%, it will move up by 15% (1.5 * 10%). And, when the index moves down 5%, the mutual fund will move down by 7.5% (1.5 * 5%).
A mutual fund’s Beta can be calculated by using the following formula:
Beta = (Mutual Fund’s return – Risk-free rate) ÷ (Benchmark’s return – Risk-free rate)
Suppose a mutual fund has delivered a return of 20% per annum, while its benchmark has provided a return of 12%. Assume the risk-free rate to be 5%. Let us use the above formula to calculate Beta:
Beta = (20% - 5%) ÷ (12% - 5%) = 2.1
Having explained what Beta ratio in mutual funds is, let us talk about main points about it.
Key points to remember about Beta
Here are the key points that you must keep in mind while using Beta ratio in mutual funds:
Beta shows the relative risk of a mutual fund compared to its benchmark index.
The word “relative” is extremely important here because it shows that Beta indicates a fund’s performance vis-à-vis its benchmark. Hence, it is not a measure of a fund’s absolute performance.
How to calculate Alpha and Beta ?
Calculating alpha and beta is not difficult. Let us first understand how to calculate a mutual fund’s beta. As discussed, Beta shows how volatile a fund is compared to its benchmark index. It is calculated using the formula given below:
Beta = [Covariance of the fund’s returns and the benchmark’s returns] ÷ [Variance of the fund’s benchmark returns]
In this formula, Covariance measures how a fund moves vis-à-vis its benchmark. The variance of its benchmark returns shows the volatility of those returns. If a fund’s Beta is equal to 1, it means it moves exactly as its benchmark. If its beta is higher than 1, it means it moves more than its benchmark. If its beta is less than 1, it shows that it moves less than its benchmark.
You must have noted that we provided another formula for Beta earlier in the blog (given below):
Beta = (Mutual Fund’s return – Risk-free rate) ÷ (Benchmark’s return – Risk-free rate)
Both the formulas of Beta are correct. You can use them based on your comfort level.
Alpha shows whether a mutual fund is able to generate a return over its expected return. Hence, alpha can be calculated using the following equation:
Alpha = A fund’s actual return – A fund’s expected return
Expected Return = [Risk-Free Rate + Beta * (Market Return−Risk-Free Rate)]
Hence, a more detailed formula for Alpha is provided below:
Alpha = A fund’s actual return – [Risk-Free Rate + Beta * (Market Return−Risk-Free Rate)]
Final Takeaway
If you participate in the stock market and are keen to invest in mutual funds, you should know what Alpha is and what Beta is in mutual funds. Alpha and Beta can help you a lot in examining the performance of mutual funds. But, while using these indicators, you should be clear about your objective. If you are not clear about your objective, you may make a mistake. Hence, you should be sure of your objective and then use Alpha and Beta.
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