The foundation of investment rests on the concept of risk and return – the financial twins that go hand in hand. Higher returns have been a product of higher risks and a sound understanding of the interplay of these two will enable you to derive maximum benefit out of the investment. Keep reading to understand how risk is measured, and the role that alpha and beta play in the same.
How is risk measured?
Risk is defined as the deviation from expected or average returns. This is often measured with the help of standard deviation. Returns on equity funds come with greater risk than debt funds and large cap funds have lesser risks than small cap funds. While calculating the returns of a mutual fund, one often comes across the term – risk adjusted returns. As the name suggests, these returns factor in the risk taken by the scheme.
The limitations of standard deviation are overcome by the use of beta ratio and the limitations of the sharpe ratio is overcome by the use of alpha ratio.
What is Alpha in Mutual Funds
Alpha and beta are instruments of the financial market used to quantify the performance of the mutual fund. Both alpha and beta are historical measures and are used to evaluate the investment portfolio’s returns over a period of time.
Alpha is used to gauge the performance of the asset manager who is tasked with guiding a fund to yield profits for its investors.
What is Beta in Mutual Funds
Beta is used to quantify the fund’s response to market volatility. It is a representation of the relative risk of the fund and not the inherent risk of investing in that particular fund. The inherent risk is revealed by another measure called the standard deviation.
Calculation of Alpha
Alpha ratio is calculated as
(End Price + {Distribution Per Share – Start Price})/Start Price.
Alpha can also be calculated with the help of the Capital Asset Pricing Model (CAPM). It is arrived at by subtracting the anticipated return from the actual return to gauge the profits that were created by the fund manager. This mode is usually used by a fund manager to see if the rate of return exceeds the model’s prediction or falls short.
Another method by which alpha can be mathematically calculated is by using the beta ratio.
Alpha = (MF Return – risk free return) – (Benchmark return – risk free return) * Beta
Calculation of Beta
In order to calculate the beta value, one must know the variance and covariance values. Here’s a breakdown of these terms:
- Covariance refers to how two different stocks/funds respond to each other in varying market conditions.
- A positive covariance means that the stocks/funds move in compliance with each other and a negative covariance means that the stocks move in opposite directions.
- Variance refers to the price deviation of the fund from its average or mean. This is representative of the price volatility of the fund across a specific period.
The beta ratio is calculated as Covariance/Variance of market’s returns.
Relation between Alpha and Beta
While it might seem like the two ratios are measurements of different parameters or metrics, they are interrelated.
It has been seen that Alpha can be calculated with the help of Beta ratio, implying the fluctuations in beta will inevitably influence the alpha values.
To understand it better, let us assume that X fund gives you a return of 10%, its benchmark returns for the same duration is 7%. The beta of the fund is 0.75 and the risk-free rate (i.e. maximum return that one can generate without any market risk, credit risk, interest rate risk, and unsystematic risk). Suppose the risk free rate of return is 3%
- Alpha will be calculated as (MF Return – risk free return) – (Benchmark return – risk free return) * = (10- 4) / (7- 4)*Beta = 1.5%.
- These figures show that the fund has managed to generate significant returns while remaining less volatile. This return in fact can be seen as a reward for its less volatile behaviour.
- If the same example were to be taken but the beta value was to be replaced by 1.3, then the alpha value would drop. This is an indication that the fund gets penalized for erratic behaviour.
If the relation between alpha and beta were to be summed up in a single statement it would amount to – alpha and beta display an inverse relationship; the higher the beta, the lower the alpha and vice versa.
How to read Alpha and Beta Ratios
Decoding alpha in Mutual funds
In order to arrive at the Alpha, one must compare the return on a specific fund against a benchmark index. For example, say a mutual fund gets a mean return of 10% on a specific mutual fund against a benchmark index of 7%. The alpha ratio would be 3, which is a good score. Investors generally opt in for mutual funds that have an alpha ratio around1.5.
A 0 in the alpha ratio implies that the fund manager has not been able to outperform the benchmark index.
Decoding Beta in Mutual Funds
Beta ratio starts with a baseline of 1. If the value were to be 1, then the fund is said to respond to the market equivalently or that the shift in the price of the mutual fund is the same as the benchmark movements.
A value that exceeds 1 in beta indicates that the fund is more responsive than the benchmark movement and the converse applies when the ratio is less than 1.
To illustrate, a beta ratio of 0.6 or 60% implies that the fund is 40% less volatile than the benchmark index. Beta values that lie at 1 show low risk and low growth potential as opposed to funds that have a figure higher than 1.
Importance of Alpha and Beta
Gauging the past performance of the mutual fund is important to make a wise investment decision. One can evaluate the probable risk, growth, sustainability to volatility ratio etc. Alpha and beta will help produce data to map out the future prospects of the fund.
An investor with a higher risk appetite, and one who wishes higher growth prospects from the mutual fund will invest in a fund that displays a beta ratio that exceeds 1.
Beta ratio is used to gauge the CAPM for it helps the investor decide whether a specific fund must be included in the investment portfolio or not.
It will help the investor identify the cause for good or poor performance of the fund. It overcomes the limitations posed by the standard deviation and sharpe ratio.
Conclusion
You could consider adding these two ratios in addition to the usual mutual fund qualitative factors like historical performance, fund manager expertise, your own risk appetite, etc while choosing the right mutual fund for investing.
FAQs on Alpha & Beta
Alpha shows the performance of a stock when compared with its benchmark. High alpha means that the stock has outperformed the market. Ideally actively managed funds should have an alpha of more than 1.
