What is Alpha and Beta in Mutual Funds?

When we talk about the financial market, alpha and beta are the two most important and commonly used instruments. 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. 

When investing in mutual funds, it is important to evaluate a fund’s past performance before making a decision. This is where knowing the beta and alpha in mutual funds becomes essential. 

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.

Importance of Alpha and Beta in Mutual Funds

Here’s why alpha and beta are important in mutual fund investments:

1. 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. 
2. Investors who wish for average returns but are not willing to take very high risks may prefer a balanced value of alpha and beta. 
3. 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. 
4. 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.

Calculating Alpha and Beta in Mutual Funds

Given below are details of how to calculate the alpha and beta metrics of mutual funds: 

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. 

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.

How to Interpret Alpha and Beta in Mutual Funds?

Here’s how you can interpret the alpha and beta in mutual funds: 

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 which 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. 

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. 

Risk Calculation Using Alpha and Beta 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. 

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. 

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.  

How is the Risk of a Mutual Fund Measured?

The prospect of losing an investment corpus is known as risk. When investors choose an investment, they should compare its levels of associated risks with returns. There are internal and external sources of risk, and it is not easy to keep track of them. However, one can measure risk using various metrics. 

Given below are the common metrics besides alpha and beta for measuring risks: 

• Standard Deviation: This metric indicates the deviation of a fund’s accrual returns from its average returns. This is one of the most commonly used metrics of risk. 

• Sharpe Ratio: It takes into consideration risk-free returns, fund returns and standard deviation. It evaluates a mutual fund’s risk-adjusted returns. 

• R-squared: It measures the connection between the mutual fund’s performance and the underlying benchmark. R-square is measured on a scale of 100. If it is 100, it means that the mutual fund’s performance is in sync with its benchmark. 

• Sortino Ratio: This metric evaluates the risk-adjusted returns of a mutual fund. It takes into account only the disadvantages of a standard deviation. 

How are Risk-Adjusted Returns of Mutual Funds Measured?

Here, the central concept is the calculation of returns based on the risk an investor has taken to get it. Risk-adjusted returns enable an investor to measure the returns that his/her investment will generate against the risks of holding it. 

The most common metric used to measure risk-adjusted returns is the Sharpe ratio. It is a useful metric which is used to determine a mutual fund’s performance against the set level of risk. The risk-adjusted performance of a mutual fund is considered to be better if the Sharpe ratio is high. 

If the investor receives a negative Sharpe ratio, it is indicative that he/she should invest in a risk-free asset instead of the asset they have invested in.

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 on Alpha and Beta in Mutual Funds

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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.