What Is the Meaning of Alpha and Beta in Mutual Funds?
As a responsible investor, it is imperative to evaluate the risks and returns of an asset before investing your money. It is imperative to understand not only the associated risks but also the risk-adjusted returns. Similarly before investing in a mutual fund, you must check the fund’s past performance, asset allocation and risk management to analyse its future potential. Alpha and beta are two such metrics that the investors can use to calculate the risks and returns of any investment instrument that is linked with financial markets.
This article will help you understand “what are alpha and beta in mutual funds”.
What is the Alpha of a Mutual Fund?
Alpha is a variable which most investors use to measure a mutual fund’s performance. It is equal to the difference in returns that a fund has generated against its benchmark index.
For mutual funds, the Alpha baseline is 0. If alpha is 0, it indicates that the fund has given the same returns as the benchmark index. If alpha is less than 0 (negative), it shows that the mutual fund has underperformed its benchmark; if alpha is more than 1, the fund has outperformed the benchmark.
For instance, if the alpha of Fund A is five, and its benchmark is NIFTY giving returns of 15%. Then the alpha indicates that Fund A returns have outdone its benchmark by 5%. Furthermore, the investor will receive 20% returns.
In another scenario, if Fund B has an alpha value of (-)5 and its benchmark index is 15%, then it has underperformed. So, the investor will receive only 10% returns.
This tool also helps to determine a fund manager’s performance in managing the fund units properly so that the fund generates high profits.
In simpler terms, the alpha value helps the investors determine how much returns they will potentially receive.
Alpha’s main job is to calculate the surplus or shortage of a fund’s performance against the benchmark indices.
What is the Beta of a Mutual Fund?
The beta value measures a mutual fund’s response to market fluctuations. When you analyse the beta of a mutual fund, you’re trying to understand the fund’s return with respect to the market volatility. The market refers to the fund’s benchmark index. .
If a mutual fund’s beta value is one, then its volatility is equivalent to the volatility of its benchmark index. If you have a low-risk tolerance, you can choose a mutual fund with a beta value of less than 1. Such mutual funds tend to react less to market fluctuations and remain more or less stable. However, if you are comfortable with taking market-related risks, you can opt for mutual funds having a beta value higher than 1. Such mutual funds are considered highly volatile and sensitive to market fluctuations.
Let’s understand this with an example. Suppose there are two funds in the market; Funds A & B. They have a beta value of 0.7 and 1.5, respectively. This means Fund A is almost 30% less volatile than benchmark, while Fund B is 50% more volatile than the benchmark.
How to Calculate Alpha and Beta in Mutual Funds?
Capital Asset Pricing Model (CAPM) formula is used to calculate a mutual fund’s alpha and beta ratio. This formula will help investors determine and create a relationship between a fund’s returns and the market-related risks. The procedure to calculate the beta value is:
Beta = (Mutual Fund Return – Risk-Free Rate)/(Benchmark Return – Risk-Free Rate)
In this formula, the risk-free rate is the return on interest you can expect to receive as an investor if the mutual fund has zero risks.
Covariance is a parameter that determines how the different types of mutual funds available in the market vary in various market conditions. Variance determines how a mutual fund’s NAV differs from its average price.
One should note that the above formulae are simplistic, and in actual practice, beta is calculated by plotting a graph of excess monthly returns against the benchmark rate.
On the other hand, the formula to calculate the alpha ratio in a mutual fund is:
Alpha = (Mutual Fund Return – Risk Free Return)/[(Benchmark Return – Risk Free Return)*Beta]
Let’s understand this with an example. Suppose a mutual fund A gives a 10% return in a year, and its benchmark gives an 8% return for the same duration. Assuming the risk-free rate to be 5%.
Beta = (10 – 5) / (8 – 5) = 1.67
This indicates that the fund is highly volatile.
Taking the same example, if a fund’s beta is 0.75, let’s calculate its alpha value.
Alpha = (10 – 5) / [(8 – 5) * 0.75) = 5 – 2.22 = 2.78
This indicates the fund’s outperformance.
Also Read: Know About Loans Against Mutual Funds
What is the Importance of Alpha and Beta in Mutual Funds?
While shortlisting any investment option, it is always advised to check the historical returns. Similarly, while choosing a mutual fund, you should look at the past performance of the scheme. However, you need to keep in mind that past performance does not influence a mutual fund’s future performance. It can only indicate a higher likelihood of good performance.
Alpha and beta are important to be evaluated when selecting a mutual fund. Investors can use them to assess a fund’s potential growth, sustainability, market-related volatility, risks, and other factors.
An investor should look into a fund’s historical values of alpha to determine the asset manager’s capability to generate excess returns. Assessing beta can help one determine whether or not the volatility of a mutual fund is suitable for their risk profile.
You can also opt for well-balanced mutual funds where both alpha and beta ratios are balanced. This is suitable for people who do not have high-risk tolerance, but also want optimal returns.
How are Risks of Mutual Funds Measured?
Alpha and beta ratios enable the investors to measure all risks and volatility accompanied by investing in mutual funds. In addition, a few other ratios like standard deviation, Sharpe’s ratio and Sortino ratio also measure a mutual fund’s risk levels and performance. These financial ratios are discussed as follows:
Standard deviation calculates how far a group of data deviates from the mean or average of the data. So, in the case of mutual funds, it shows how far the fund’s returns have deviated from the mean or average compared to the historical returns over various market conditions.
This measures the potential risk-adjusted returns of a mutual fund using the standard deviation. Risk-adjusted returns are returns that an investment generates over and above the risk-free return. Sharpe ratio helps understand the return yielding capacity of a fund for every unit of volatility (risk). .
Sortino ratio also measures the risk-adjusted returns of a mutual fund by considering only the downside of the standard deviation. So, it assesses the performance of a fund for each unit of downside risk involved in the investment.
When investing in a new mutual fund in the market, investors should always evaluate the alpha and beta ratios of a particular mutual fund. This will help them make better and informed decisions.
In addition to alpha and beta ratios, there are other ratios as mentioned above that affect the returns and performance of a mutual fund.
Frequently Asked Questions
Are there other ratios, in addition to alpha and beta, to evaluate the performance of a mutual fund?
Other than alpha and beta ratios, the following ratios help investors quantify a fund’s performance with the help of historical data and help in comparing with the versions of other similar mutual funds in the market:
Price-to-earnings ratio (P/E ratio)
What is the P/E ratio of a mutual fund?
Price-to-earnings ratio (P/E)is a valuation metric that represents how much price the market is ready to pay for each unit of earnings of a stock. In the case of mutual funds, the P/E is calculated by taking the weighted average P/E of its underlying stocks in proportion to their holding percentage.
How are alpha and beta ratios related in a mutual fund?
Alpha and beta are inversely proportional to each other in any mutual fund. If the alpha ratio is high in a mutual fund, then the beta ratio in that mutual fund will be low and vice versa.