Whenever we talk about performance, it is always relative, isn't it? Remember when your board exam results came out, your performance was always measured against an older sibling or the neighbourhood topper. These people were the benchmarks, and your score was relative to theirs. In mutual funds, this benchmark is the index that the mutual fund tries to match or beat depending on the investment objective. An essential aspect of performance is the risk associated with it. You'd want an ideal mix of both. But how do you figure this out? Don't worry; you can find readymade metrics to help you: Alpha and Beta.
Keep reading to learn what are Alpha and Beta in mutual funds.
What is Alpha in mutual funds?
Alpha is a metric that helps you understand the performance of your mutual fund. It is a metric that pits a mutual fund's performance against an index. If the returns earned by the mutual fund are more than those earned by the index in a set timeframe, you may consider investing in that mutual fund.
The baseline for Alpha is 0. It means that if the value of Alpha for a mutual fund is 0, it earns the same returns as the benchmark index. An Alpha over 0 indicates that the mutual fund earns more than the index, while an Alpha less than 0 suggests that the fund underperforms an index.
Investing in a fund having an Alpha of more than 0 could be favourable as the fund has a history of outperforming the benchmark index.
What is Beta in mutual funds?
Risk is a critical metric in mutual fund investments. Beta measures this feature and helps you assert whether the fund meets your risk profile. Beta calculates the volatility of a mutual fund by comparing it against a benchmark index. It tracks the performance of a mutual fund in varying market conditions and designates a value to it.
The baseline for Beta in mutual funds is 1. A fund with a Beta over 1 is more volatile than the benchmark index. If it is equal to 1, the fund is as volatile as an index. A Beta less than 1 signifies that the mutual fund is less volatile than the benchmark index.
Funds with a Beta over 1 carry more risk but may offer high returns. You can invest in them if it meets your risk profile.
How are Alpha and Beta calculated?
Alpha and Beta are calculated using the Capital Asset Pricing Model (CAPM) formula. The CAPM helps calculate an asset's risk-adjusted returns. The Alpha and Beta formulas using CAPM are as follows:
Beta = (Mutual fund return – risk free rate (Rf)) / (Benchmark return – risk free rate (Rf))
Similarly, the formula for Alpha is:
Alpha = (Mutual fund return – risk free return (Rf)) – [(Benchmark return – risk free return (Rf)) * Beta]
Here's an example to better understand the Alpha and Beta of a mutual fund. Assume a mutual fund offers 20% returns in a year, while the benchmark index gives 15%. If we assume the risk-free rate to be 10%, Beta comes out as:
Beta = (20 - 10) / (15 - 10)
Beta = 2
It indicates that the mutual fund we assumed is twice as volatile as the benchmark index. Let us calculate Alpha for the same fund assuming Beta as 1.
Alpha = (20 – 10) - [ (15 – 10) * 1)
Alpha = 10 - 5
Alpha = 5
It indicates that the fund outperforms the benchmark index, making it an appealing investment option.
You can use Alpha and Beta and other risk measures to determine if a mutual fund fits your risk profile and investment goals. Both tools can also develop your investment skills.
How to interpret Alpha and Beta in mutual funds?
The baseline value of Alpha and Beta in mutual funds is 1 and 0, respectively. You can conclude a mutual fund based on fluctuations on either side of this baseline.
What is the importance of Alpha and Beta in mutual funds?
Alpha and Beta help determine a mutual fund's risk and expected returns.
How to calculate Alpha and Beta in mutual funds?
Using the Capital Asset Pricing Model (CAPM) formula, you can calculate Alpha and Beta in mutual funds.
The information herein is meant only for general reading purposes and the views being expressed only constitute opinions and therefore cannot be considered as guidelines, recommendations or as a professional guide for the readers. The document has been prepared on the basis of publicly available information, internally developed data and other sources believed to be reliable. The sponsor, the Investment Manager, the Trustee or any of their directors, employees, associates or representatives (“entities & their associates”) do not assume any responsibility for, or warrant the accuracy, completeness, adequacy and reliability of such information. Recipients of this information are advised to rely on their own analysis, interpretations & investigations. Readers are also advised to seek independent professional advice in order to arrive at an informed investment decision. Entities & their affiliates including persons involved in the preparation or issuance of this material shall not be liable in any way for any direct, indirect, special, incidental, consequential, punitive or exemplary damages, including on account of lost profits arising from the information contained in this material. Recipient alone shall be fully responsible for any decision taken on the basis of this document.
Past performance may or may not be sustained in the future and the same may not necessarily provide the basis for comparison with other investment.
Mutual Fund Investments are subject to market risks, read all the scheme related documents carefully.