Financial Term of the week- Alpha (α)

Before understanding Alpha, let’s take a quick diversion to Beta (β). Every mutual fund scheme has a benchmark index whose performance it aims to match. In the process, it sometimes performs better and sometimes worse than the benchmark. What you, as an investor, may be interested in knowing, is the extent of this performance fluctuation over the benchmark. This risk is represented by Beta (β); you can read more about it here.

For example, if the benchmark index gives a return of 10% and the β of the scheme is 1.2, this implies that the scheme can give you +12% when the market is favourable and -12% when it is not. This is the mutual fund scheme’s reaction to the moving markets and the effect of this volatility on the scheme’s performance. Now, suppose on a favourable market run, the same scheme gives you a return of 15%, which is above the benchmark and much above the predicted returns as per β. What do you think has caused this outperformance (15%-12%= 3%) over the β predicted returns? It is the fund manager’s expertise, and this measure to determine the performance of the fund manager is called Alpha (α), which in this case, is 3%.

Understanding Alpha (α)

Alpha is the extra return that a fund manager can generate over and above the fund’s benchmark. Alpha is computed in relation to Capital Asset Pricing Model (CAPM). Alpha compares the realized return of the portfolio and the required return, as determined by CAPM.

Alpha can be calculated as below:

α = Rp – [Rf + (Rm – Rf) β]

Rp = Realized return of portfolio

Rm = Market return

Rf = the risk-free rate.

β = the asset's beta

Let us consider an example:

Assuming a mutual fund generated a return of 15%. The appropriate market index for this fund returned is 10%. The beta of the fund versus the index is 1.2, and the risk-free rate is 4%.

Alpha = 15% - (4% + 1.2 x (10% - 4%)) = 15% - 11.2% = 3.8%.

The baseline of alpha is 0. If alpha is negative, it implies that the fund manager’s performance may have been questionable since he failed to meet the benchmark performance. Likewise, a positive alpha shows a good performance by the fund manager. A fund will have to consistently generate α that is positive for the fund manager’s expertise to be recognized and accepted. A one-time α-generation may not mean anything.

The passive funds which replicate a portfolio like the benchmark indices have an α of 0. This is because there is no role of the fund manager in these schemes. Just because the α is positive, does not mean that the scheme is worth investing in. You may want to compare the α and β values of similar mutual fund schemes in order to understand how one is better than the other or how prone to the risk they both are and hence, how much fluctuation in returns is acceptable to you.

Get on to the driver’s seat, understand, and start reading the α values of different schemes. This may help you pick the scheme better suited for your needs and goals. For any further information, you may contact your financial advisor.