What is Alpha in mutual funds? How is it calculated?

Risk and returns analysis is the key to having a successful portfolio. This analysis is on the micro as well as macro levels i.e., firstly understanding the individual risk perception and returns expectations and then on the industry or economic levels. This risk-return analysis is what differentiates between a quality mutual fund and an average one. Alpha and beta are the most popular metrics to measure the performance of a fund and help in the decision-making process. 

Given below is the meaning of alpha and how it is measured to determine the performance of a fund and in extension the competence of the fund manager. 

What is Alpha?

Every investor while picking funds for investment always considers the returns from the fund at various intervals to understand its performance under various tenures and market cycles. These returns are a reflection of the composition of the fund and the strategies adopted by the fund manager to achieve the fund objective and meet the expectations of the investors. As per SEBI guidelines, every fund has to set a benchmark index that they follow and use as a standard to measure their relative performance as well as that against other funds. The alpha factor, after that, is used to measure the performance of the fund against its benchmark. The fund manager and the investors can analyze the alpha derived to understand if the fund is underperforming or overperforming. 

The baseline for alpha in mutual funds is zero. If the alpha of the mutual fund is more than 0 or positive, the fund is said to be performing better as compared to the benchmark. Similarly, if the alpha of the fund is less than 0 or negative, the fund is considered to be underperforming as compared to the benchmark. This analysis allows the fund managers to undertake corrective measures in the composition of the fund or the strategies used to achieve the fund objective. 

Also Read: How do you measure the performance of mutual funds with trailing and rolling returns

What is Beta?

Just like alpha is used to measure the performance or the returns of the fund, the beta factor is used to determine the fund’s vulnerability or risk when compared to the benchmark. The baseline of the beta for a mutual fund is always 1. If the beta of the fund is more than 1, it implies that the fund is more volatile or reactive to the market and the risk of investment is higher. On the other hand, if the beta of the fund is less than its baseline or less than 1, it implies that the fund is less volatile and can be classified under the lower risk fund category. 

How are Alpha and Beta calculated?

The calculation of alpha and beta is based on the Capital Asset Pricing Model (CAPM). This model helps in determining and understanding the relationship between the returns and the risk of any investment like mutual funds.

The formula for the calculation of Alpha and beta is given below. 

Alpha = r- Rf-beta (Rm-Rf)

Where, 

• r = the fund’s return
• Rf = the risk-free rate of return (usually government securities)
• Beta = the fund’s price sensitivity or volatility when compared to the overall market
• Rm = the market return

Beta = (r – Rf) ÷ (Rm – Rf)

Where, 

• r = the fund’s return
• Rf = the risk-free rate of return (usually government securities)
• Rm = the market return

Let us consider an example to understand the calculation of alpha and beta of the fund. 

Consider Fund A which has a return of 25%, the beta of the fund is 1.5, the risk-free rate is 10% and the market return is 15%. The alpha of the fund will be calculated as under.

Alpha = (0.25 – 0.10) – 1.5(0.15-0.10)

Alpha = 0.075 or 7.5%

This implies that the fund has outperformed the index by approximately 7.5%.

Consider Fund B having returns of 15% and market returns of 12% and the risk-free return is 10%. The beta of the fund is calculated as under. 

Beta = (0.15-0.10) / (0.12-0.10)

Beta = 2.5

The beta of the fund, in this case, is 2.5 which makes this fund highly volatile as compared to its benchmark. The fund is categorized under high-risk funds and investors should be aware of the such risk before investing in the same. 

Why are Alpha and Beta significant in mutual fund returns?

The calculation of alpha and beta is of paramount importance while investing in a fund. These factors allow the investors to understand the expected returns and the risk of investing in a fund which allows them to make sound investment decisions. The historical returns of the fund are a reflection of the past performance of the fund and its ability to generate returns in different market cycles. However, past returns are not a guarantee of a favourable future performance. Hence, complete reliance on them is not advisable. However, these historical returns are a good yardstick to measure the ability of the fund manager to navigate the fund and alter its compositions in the face of market volatility. 

Also Read: Should you rely on mutual fund past performance to invest?

Calculation of alpha at different time intervals allows the investors to understand the relative performance of the fund at different intervals. This can help them in deciding the optimum investment horizon along with aligning their investment goals to achieve maximum returns. 

The beta factor, on the other hand, provides information regarding the risk of investing in a fund. If the beta of the fund is high, it can caution the investors if it does not align with their individual risk appetites. Therefore, investors with lower risk appetites can opt for funds with lower beta and vice versa. 

Conclusion

Alpha and beta along with many other ratios like Sharpe Ratio, Standard Deviation,, etc. are used to make investment decisions by the investors. Alpha and beta, however, are the most common parameters often used by investors. These parameters are easy to understand and interpret making them more popular among the other parameters. 

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