What are alpha and beta in mutual funds?

The key to getting better returns on mutual fund investments is making a profitable investment in the first place. For this, evaluating the performance of different funds is important before making an investment decision. Now the question is- how do you know if a given fund is performing well? Well, you look at performance parameters or use tools to measure them.

The two most common instruments to judge fund performance are alpha and beta. Let’s look at both these instruments and understand how they can help you select a profitable fund in detail.

What is alpha?

When you invest in a mutual fund, you want it to get good returns. This depends on how well your funds perform in the market conditions. Typically, fund performance is measured against the benchmark companies' performance using alpha. And the better the past performance, the better the future performance.

The alpha value of a mutual fund could be negative, zero or positive. If the alpha is 0, the fund gives the same returns as the benchmark. However, if the alpha value is positive or negative, your mutual fund has outperformed or underperformed the benchmarks, respectively.

Let’s understand this better with an example.

If you invest funds in the stocks of a company that has NIFTY as a benchmark, its performance is measured against it. So, if NIFTY gets a return of 10% in a year, and your fund’s alpha is 2 in the same year, it means your fund got 2% better returns than NIFTY. In other words, your returns are 12% for the same year. Similarly, if the alpha of your fund is -3 for a particular year, your funds underperformed by 3% compared to NIFTY. So, your returns would be 7% compared to the expected minimum of 10%.

Along with mutual fund performance, alpha can also help you assess your fund manager's efficiency. That’s right. You can measure the alpha value of funds in your portfolio and determine the skill of your manager in curating a good portfolio.

Now that we know what the alpha metric is all about, let’s understand the beta metric.

Additional Read: Understanding Mutual Fund Terminologies

What is beta?

Mutual fund performance depends on the market conditions. Beta helps you measure the returns a fund can give you as the market conditions fluctuate compared to the benchmark. So, you can use beta to help you decide whether or not you want to invest in a given fund based on its market sensitivity.

The beta value can be less than 1 or greater than 1. Funds with a greater beta are high-risk and more responsive to market fluctuations and vice versa. Let’s take a look at an example.

If a mutual fund has a beta of 0.2, the fund is 80% less volatile than its benchmark. However, if the beta is 1.4, the fund is 40% more volatile compared to its benchmark.

How are alpha and beta calculated?

There are two formulae for calculating beta-

- Beta = (Mutual Fund Return - Risk Free Rate)/(Benchmark Return - Risk Free Rate)

Here risk-free rate is the return on interest an investor can expect if the funds have zero risks.

- Beta = Covariance/ Variance

Here covariance is the measure of how different mutual funds vary from each other in different market conditions. The variance is how different the fund’s price is from the market price.

The formula for calculating alpha is as follows.

- Alpha = (Mutual Fund Return - Risk Free Return)/[(Benchmark Return - Risk Free Return)*Beta]

Here risk-free rate is the returns an investor can expect if the funds have zero risks.

Additional Read: Simple Strategies to Build Wealth with Mutual Funds In 2022

Alternatives to Alpha and Beta

Standard deviation

Standard deviation measures the risk of a mutual fund by measuring how much the returns deviate from the average returns. A higher standard deviation indicates that the fund is more volatile and risky, whereas, a lower standard deviation suggests consistent performance.

Sharpe ratio

Sharpe ratio measures a fund's risk-adjusted return. It is calculated as the difference between the fund’s return and the risk-free rate, divided by the standard deviation.

P/E ratio

The price-to-earnings ratio shows the price investors are willing to pay for each rupee earned by a single unit of the fund. A higher P/E ratio indicates the high growth potential of the business. However, it could also suggest the stock is overvalued.

R-squared

R-squared measures the percentage of fund returns that match up with the changes in the current benchmark index. The higher the r-squared, the more correlated the fund's performance with the market.

Conclusion

Thus, alpha and beta metrics help investors decide if they should invest in a mutual fund based on their performance and susceptibility to market fluctuations.

Now that you know about alpha and beta, ready to start investing? Use the Moneyfy app from Tata Capital to view various mutual funds and manage your investments on the go.

Frequently asked questions

1. How to interpret alpha and beta in mutual funds?

A positive alpha means the fund has outperformed its benchmark, whereas, a negative alpha means the fund has underperformed its benchmark. On the other hand, a beta of 1 indicates the fund’s volatility matches the market, a beta more than 1 indicates the fund is more volatile than the market, and a beta less than 1 indicates the fund is less volatile than the market.

2. How to measure mutual fund risk?

You can measure mutual fund risk through various metrics like:

- Alpha

- Beta

- Standard deviation

- Sharpe ratio

- P/E ratio

- R-squared

3. What is the importance of alpha and beta in mutual funds?

Alpha helps you determine the fund's potential to generate returns beyond what the market offers. On the other hand, beta helps you understand the fund’s risk relative to the market.