What is Alpha and Beta in Mutual Funds: Importance, calculation and more
There are a number of investment instruments out there in the financial market. Investors have to evaluate the performance of different funds in order to make a profitable investment. This is done by using different parameters. The two most commonly used tools to measure the performance of any investment instrument are alpha and beta. These two tools measure a fund’s performance, relation, and response with/to the market changes.
- Alpha and Beta are two different variables used to evaluate the performance of a mutual fund scheme.
- Alpha measures the excess or deficit in a fund’s performance against a benchmark index.
- Beta is a measure of fluctuations in the fund against the fluctuations in a benchmark index.
- Alpha and Beta are used to calculate a mutual fund’s performance and stability with respect to the equity market.
What is Alpha?
Alpha is a parameter to evaluate the performance of the asset manager for his/her efforts in driving the fund to return profits as compared to a benchmark index. A benchmark index is set against which the performance of the fund is measured in terms of alpha.
Alpha of a mutual fund has a baseline of 0. The values of alpha greater than, equal to, or less than the 0 show the fund’s performance against the benchmark index. For example:
- If the value of alpha is greater than 0, it means that the fund is performing better than the benchmark index.
- In case the value is less than 0, it means that the fund is underperforming when compared to the benchmark index.
- If the value is equal to 0, it means that the fund is performing exactly the same as the benchmark index.
|Value of Alpha||Performance of the Asset Manager|
|=0||Performance precisely in line with the Index|
What is Beta?
Beta is used to measure a fund’s response to the fluctuation in the market. Beta in mutual funds measures how the fund is showing variations with the changes in a benchmark index. It shows the sensitivity of a mutual fund to the fluctuations happening in the index. The value of beta defines how stable the fund is performing during a volatile market period.
In mutual funds, the beta has a baseline of 1. Values greater than, equal to, or less than 1 show the sensitivity of the funds with respect to a benchmark index. For example:
- A beta value greater than 1 tells that the mutual fund is more sensitive to the changes in the benchmark index, i.e. the fund is showing more volatility than the index.
- A fund with a beta value equal to 1 has the same variation as that of the benchmark index.
- A beta value less than 1 shows that the fund is less responsive and is showing lesser deviations in response to the changes in a benchmark index.
|Value of Beta||Sensitivity of the Fund|
|>1||More Variation than the Benchmark Index|
|=1||Same Variation as that of Benchmark Index|
|<1||Less Variation than the Benchmark Index|
Importance of Alpha and Beta
- It is important to evaluate a mutual fund’s past performance before making any investment. Although past performance does not necessarily imply the same course for future performance, it is still a key method to make sound investment decisions. Alpha and Beta can help investors evaluate a fund’s performance, and volatility compared to a benchmark index.
- Investors can take advantage of the beta ratio to make investments as per their risk appetite. Risk averse investors can avoid funds with a beta value much higher than 1, or vice versa.
- Investors can use the alpha ratio of a fund to evaluate the fund manager’s performance. A value greater than 0 shows that the fund manager has done well in managing the fund to generate higher returns.
- A balanced value of alpha and beta is preferred by investors who do not wish to take extreme risks and want more than average returns.
Calculation of Alpha and Beta
Alpha in mutual funds is calculated using the following formula:
Alpha = (End Price – Start Price + DPS) / Start Price (DPS = Distribution Per Share)
There is also an easy way to calculate the alpha of a mutual fund using CAPM (Capital Asset Pricing Model). Since CAPM shows the predicted returns that can be expected from a mutual fund, any deviation from its value will be the same as that of alpha.
For example, if a fund’s CAPM is 8% and the actual returns stand at 12%, the difference shows that the asset manager of the fund managed to generate 4% higher returns than what was expected. This means that the value of alpha is 4.
Beta in mutual funds is calculated using the following formula:
Beta = Covariance / Variance
Here, the Covariance shows how two different instruments vary from each other in different market conditions, while the Variance shows how the fund’s price varies from its average price and defines how the volatility in the fund’s price over a specific period of time.
How Risks are Measured in Mutual Funds?
Alpha and beta give investors a way to measure risks and volatility associated with investing in a particular mutual fund. This helps them to compare different mutual funds and choose the ones that fit closely to their risk tolerance and investment expectations.
The value of Alpha tells the risk adjusted performance of a mutual fund. Any excess or deficit in the fund’s performance over a benchmark index shows the success or failure of the asset manager. Let us suppose that you have invested in a mutual fund that has Nifty 50 as its benchmark index. Now if the index has given a 10% return in a specific period, while the mutual fund generated a 12% return, it means that the fund has outperformed the index by 2%, and the value of alpha will be 2. Similarly, if the fund has generated a 7% return, which is 3% less than that of the benchmark index, the value of alpha will be -3.
The value of beta shows the sensitivity of a mutual fund to a benchmark index. For example, if the value of beta is 0.8, it means that the fund is less volatile. In other words, for every rise or fall of 100% in the benchmark index, the mutual fund has grown or fallen by 80%. Similarly, if the value is 1.2, it means that the fund is more volatile and for every rise or fall of 100% in the index, the fund has grown or fallen by 120%.
Alpha and Beta are two key ratios to measure a mutual fund’s performance compared to a benchmark index. When used with other indicators and ratios, you can make better and sound investment decisions and generate higher returns from your investments.