Alpha and Beta in Mutual Funds, Their Importance and Interpretation
When investing in mutual funds, it is important to evaluate a fund’s past performance before making a decision. This is where knowing about alpha and beta in mutual funds becomes essential.
Alpha and Beta in Mutual funds are two different variables used to quantify the response, performance, and interaction of a mutual fund scheme in the stock market. They are used to calculate a mutual fund’s performance and stability in an equity market.
This article is a detailed guide to understanding the concept of alpha and beta in mutual funds, calculation, importance and interpretation. Read on!
What is Alpha in Mutual Funds?
Alpha is one of the most important metrics for measuring a mutual fund’s overall performance. It tells us how high or low a fund’s returns were against its benchmark index. The alpha in a mutual fund also measures a certain fund manager’s skills. It evaluates his/her success in steering a mutual fund scheme to generate as much profit as possible.
What is Beta in Mutual Funds?
Beta refers to a metric used for measuring a mutual fund’s sensitivity to market fluctuations. It displays a fund’s fluctuations against that of its benchmark index. A beta in a mutual fund tells you how stable its performance was during volatile market conditions. You can also check a certain fund’s beta to understand the reasons for its outperformance against its benchmark.
How to Calculate Alpha and Beta in Mutual Funds?
Given below are details of how to calculate the alpha and beta metrics of mutual funds:
1. Alpha in Mutual Funds
Alpha = (Final Price – Starting Price + DPS) / Starting Price
Where, DPS = Distribution per share
You can easily calculate alpha in a mutual fund with the help of CAPM (Capital Asset Pricing Model). It shows a mutual fund’s expected returns and a deviation from the CAPM value will be the same as that of the alpha value.
2. Beta in Mutual Funds
Beta = Covariance / Variance
Where, covariance displays the way in which two different funds in varying market situations can be quite different from each other. Meanwhile, variance is a metric that displays how a fund’s price can fluctuate over time against its average price over a certain time.
Importance of Alpha and Beta in Mutual Funds
Here’s why alpha and beta are important in mutual fund investments:
- These are essential metrics for calculating the historical performance of a mutual fund. The alpha and beta will help people in examining and comparing a mutual fund’s performance and volatility against its benchmark.
- Investors who wish for average returns but are not willing to take very high risks may prefer a balanced value of alpha and beta.
- The beta ratio of a mutual fund helps investors make investment-related decisions based on their own risk appetite. For example, those who have a low-risk appetite can avoid mutual funds with a beta value greater than one.
- The alpha ratio assists investors in evaluating a fund manager’s history of delivering good returns. It indicates whether a mutual fund is worth investing in or not. If the alpha value is more than zero, it may indicate an exceptional performance of the fund manager.
How to Interpret Alpha and Beta in Mutual Funds?
Here’s how you can interpret the alpha and beta in mutual funds:
1. Interpretation of Alpha
Alpha in a mutual fund denotes the risk-adjusted returns of a particular fund. Generally, a higher alpha value will denote higher returns, but this is not the only criterion that helps people make investment-related decisions.
The baseline for the alpha in a mutual fund is zero. A negative alpha indicates that a mutual fund has not performed well compared to the benchmark index. Moreover, it indicates the poor performance of the fund manager.
If the alpha in a mutual fund is positive, it indicates satisfactory performance on the part of the fund manager. It indicates that the fund is performing better than the underlying benchmark index. If the alpha is zero, then the mutual fund is in line with the benchmark index.
2. Interpretation of Beta
Beta shows how a mutual fund responds to market conditions. In other words, it shows if a fund’s returns move up or down in correlation with the market.
The baseline of benchmark indices is always one. If the beta in a mutual fund is more than one, it indicates higher volatility of the investment. This means that the fund is more sensitive to the changes that happened to the benchmark index.
If the beta value is less than one, the mutual fund is not as responsive and shows lesser deviations compared to the benchmark index.
How are Risks Calculated in Mutual Funds?
Both alpha and beta ratios in mutual funds measure risks and volatility. Both ratios take into consideration factors like benchmark returns, a particular scheme’s returns and risk-free returns to calculate risks.
Here is how alpha and beta are used to calculate risks in mutual funds:
1. Alpha
The alpha value tells you about the excess returns of a mutual fund in relation to its benchmark for a certain amount of risk taken by the scheme. In case of a market outperformance, you can check the alpha value to know if it happened due to the fund manager’s skill or taking excessive risks.
2. Beta
The beta in a mutual fund shows how much risk it took in relation to the market or its relevant benchmark. So, if a fund outperforms its benchmark, you can check its beta to know its risk of volatility.
Final Word
Investors should take alpha and beta calculations into account before investing in any mutual fund. While alpha in a mutual fund measures the fund manager’s performance, beta evaluates the scheme’s performance in a volatile market. The interpretation of alpha and beta provides crucial information about whether an investor should invest in a fund or not.
FAQs
Ans: Experts consider a beta under 1.0 as good. This is because this particular beta in a mutual fund is considered to be not volatile. Experts recommend a beta of 1 or less than 1. If an investor’s fund beta is less than 1.0, he/she needs to ensure that the alpha is high.
Ans: A high alpha means that the mutual fund has done overwhelmingly well compared to the market. Alpha indicates the fund’s performance when it is compared with the underlying benchmark. Generally, actively managed mutual funds have an alpha greater than 1.
Ans: In simple words, alpha and beta in mutual funds are inversely related. If the alpha in a mutual fund is high, its beta will be low. If the beta is high, the alpha will go down. Additionally, you can calculate alpha in a mutual fund by using its beta ratio.
Ans: If alpha in mutual funds is above zero, experts consider it to be a good alpha. If a mutual fund scheme consistently has a high alpha, it is indicative of the prospect of long-term returns.
Ans: A mutual fund’s beta helps determine the risk of an investment. It allows investors to decide the performance of a mutual fund based on the risk factor. Additionally, it helps in predicting a fund’s NAV’s movement along with its volatility.
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Disclaimer: Mutual Fund investments are subject to market risks, read all scheme-related documents carefully.
This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
