You must have traversed the factors like risk profile, the objective of investment, tenure, and ratings while picking the right mutual funds to invest in. But how do you assess the financial performance of the funds so that the returns on the investment meets your expectations?
While there are metrics like Standard Deviation, Sharpe Ratio, P/E Ratio, and R-Square, Alpha and Beta are the two ‘go-to’ metrics for gauging the performance and response of the fund against the benchmark.
Before walking ahead, let’s take a concise understanding of the benchmark index as you’ll encounter this term quite often in the article. The SEBI has made it mandatory for fund houses to determine a benchmark index. This index could be Sensex, Nifty, CNX Midcap and Smallcap or others. The benchmark index provides a standard point of reference for the comparison of a mutual fund’s returns.
This article covers:
What is Alpha?
Alpha measures the performance of the fund in comparison to the performance of the benchmark market index it tracks. In some ways, Alpha is a measure of the performance of the fund manager itself. It measures the endeavours put in by the fund manager to drive the fund to yield handsome returns.
Note: The baseline for Alpha is taken as 0.
- An alpha of 0 would mean the fund manager’s performance is exactly in line with the benchmark index. That is, the mutual fund would generate precisely the same return as the benchmark index.
- A positive alpha denotes that the fund manager has outperformed the benchmark index in terms of returns. Apha of 1.0 means the fund has outperformed the index by 1%.
- A negative Alpha signifies that the fund manager is underachieving. A -1.0 alpha indicates 1% underperformance.
What is Beta?
Beta is a measure of the responsiveness of a mutual fund vis-a-vis its benchmark index. It points out how sensitive a mutual fund is to the fluctuations in the benchmark index.
The idea behind the indicator Beta is to gauge the stability of the mutual fund. A mutual fund should not take wild swings and should be capable of absorbing any wild momentum in the benchmark index.
Note: Beta is baselined at 1.
- A beta of 1 indicates that the mutual fund shows the same deviations as the benchmark index.
- A beta > 1 means the mutual fund is overly responsive to the benchmark index. For example, if a fund portfolio’s beta is 1.2, it is theoretically 20% more volatile than the market.
- A beta < 1 indicates that the fund is relatively stable and doesn’t change to the extent the benchmark index does.
- An alpha below 0 indicates the underperformance of the asset manager.
- An alpha above 0 indicates the asset manager has outperformed the benchmark.
- A beta of above 1 means the fund is more responsive to market volatility than the benchmark.
- A beta under 1 means the fund is less responsive to market volatility than the benchmark.
Importance of Alpha and Beta
Past performance of a mutual fund can be of great help while making informed decisions. Though past performance is not an assurance that the fund will perform in the future, it still gives a baseline to compare the mutual fund among its peers.
When gauging the fund’s history and track record, ratios like Alpha and Beta are of great help. In addition, they help with the projection of prospects like viability, growth, and sustainability of the fund.
Alpha reveals how competent the fund manager has been in generating profits in the past, how well they deal and how quickly they adapt to the changing market scenarios. An investor would be best placed to make a call depending on their financial objectives and risk appetite when they are familiar with the past performance and the fund manager’s capabilities.
Likewise, Beta signifies how volatile a mutual fund has been in the past in response to volatility in the market. A mutual fund with a higher beta would be a sensible pick for an investor looking to invest aggressively and reap some quick returns in a shorter run. A smaller upside surge in the benchmark index would result in the mutual fund moving exponentially.
Similarly, for an investor with a modest-to-safe approach, a mutual fund with a lower beta could be ideal as the fund won’t react as wildly to the market fluctuations and yield a steady return.
Calculation of alpha and beta ratios in mutual funds
Alpha can be calculated using the formula:
(Closing price – Open price + DPS)/Open price
Here, DPS stands for distribution per share. Suppose the Alpha for a mutual fund comes out to be 4, it means that the asset manager has reaped 4% higher returns than the benchmark index.
Beta can be calculated using the formula:
Covariance/Variance of market’s returns
Here, covariance is the measure of how two stocks react to each other in changing market conditions. When the two stocks move in unison, a positive covariance is achieved. In contrast, covariance is negative when the two stocks move in different directions.
Variance represents the price deviation of the fund over a given period. Thus, it quantifies how much the price of the fund has deviated from its mean.
Other ratios worth considering
Alpha and Beta arguably are the most widely used ratios to evaluate a fund’s performance but not the only ones. As mentioned above as well, there are Standard Deviation, Sharpe Ratio, P/E Ratio, and R-Square, among others, to get meaningful insights on the fund’s performance. Let’s get to know each one in brief:
Standard deviation: it evaluates the quantum of volatility of the fund. Standard deviation determines the deviation a mutual fund’s price has undergone from its mean in different time periods.
Sharpe Ratio: it is used to quantify the returns at changing levels of risk. Sharpe Ratio is reached by subtracting the risk-free return from the portfolio return. Generally, it is calculated every month and compiled annually for better understanding.
Sharpe Ratio = (Average returns of the fund − Risk-Free Rate) / Standard Deviation of fund’s return
R-Squared: it is a statistical tool devised to measure how identical the mutual fund’s performance is to its benchmark. R-Squared has a range of 0-100. An R-Squared value of 100 would mean that movements in the benchmark index explain all the actions of the mutual fund. While a lower R-Squared value, let’s say 25, means movements in the benchmark index only explain 25% of the mutual fund activities.
Alpha and Beta along with the ratios mentioned above help decipher the complete understanding of a fund and give ample information to enable us to make conjectures about the future. It is essential to develop an understanding of these ratios to be able to select the right fund in conjunction with your investment objectives.