While researching investments like stocks and mutual funds, you’ve probably come across terms like alpha and beta. These two measurements are among the many essential factors that help investors understand the risk and performance related to an investment, so it’s important for investors to learn how they can use them to their advantage.
Alpha is used to measure the amount of excess returns generated by an investment relative to its benchmark, meanwhile beta tells us about the level of volatility in the fund relative to the market. All of this might sound technical right now, but don’t worry! By the time you are done reading this article, you’ll understand alpha and beta in mutual funds and will confidently be able to use them to make better investment decisions.
Understanding Alpha in Mutual Funds
Let’s begin by answering what is alpha in mutual fund investments. Every mutual fund has a benchmark or index that it aims to track or outperform. For example, an ELSS fund may be benchmarked against indices like S&P BSE 500 – TRI or NIFTY 500 – TRI. These benchmarks represent the overall market performance, and the fund manager’s goal is to either exceed their returns or at the very least match them. Active management attracts a higher expense ratio, so it’s important to ensure that the fund manager is actually delivering higher returns than the benchmark to justify the additional costs.
The alpha in mutual fund investments tells you whether the fund manager’s decisions have added value beyond what the market would have delivered on its own. That is, had you simply invested in an index fund that tracks the benchmark, would you have earned similar or better returns without paying for active management? In other words, the alpha ratio in mutual funds tells you how well or how poorly a fund is performing relative to its benchmark. It is represented as a number, like 4 or -1. A negative alpha means the fund has returned less than its benchmark.
Let’s say we want to compare the alpha of two large-cap funds to understand which one has performed better compared to its benchmark. If Fund A has an alpha of 2.5 and Fund B has an alpha of 1, this means Fund A has generated 2.5% returns more than its benchmark, while Fund B has only generated 1%. In this case, we can say that the fund manager of Fund A has added more value with active management.
Jensen’s Alpha
This alpha is calculated through a different method. Here, we use a risk-adjusted approach to find out whether a fund’s extra returns over the benchmark are truly due to the skill of the fund manager or just a result of taking on more risk. It is given by the formula:
Jensen’s alpha = Ri – (Rf + B * (Rm – Rf))
Where,
- Ri = Fund manager return
- Rf = Risk-free return (Government security returns)
- B = Beta
- Rm = Market return (return of the benchmark index, e.g., NIFTY 500 – TRI)
When the alpha is zero, it indicates the returns generated by the fund consistently track the benchmark.
Understanding Beta in Mutual Funds
Now on to tackling what is beta in mutual fund investments. Beta is used to measure a fund’s volatility (systematic risk) compared to the overall market. It tells you how much a fund’s returns would fluctuate when the market goes up or down. Here’s how the value of the beta ratio in mutual funds can be interpreted:
1. When beta = 1
This is the baseline of beta. A mutual fund with 1 beta would move in line with the market. For example, if the market goes up by 5%, the fund is also expected to rise by approximately 5%. And if the market goes down by 3%, the fund’s returns will also reduce by 3%.
2. When beta > 1
A beta greater than 1 suggests the scheme carries higher volatility compared to the benchmark. Growth-oriented and aggressive funds usually have a higher beta value because they invest in high-risk, high-reward stocks like mid-cap and small-cap companies. They deliver higher returns during bull markets but also come with the risk of losing value when the market is down.
3. When beta < 1
A low beta indicates low volatility. Funds with low beta tend to prioritise protecting the downside which naturally limits the upside.
Your mutual fund selection should align with your risk appetite. You can use beta in mutual fund investments to understand different funds’ risks relative to the market. The word relative is crucial here as beta doesn’t measure absolute risk – it simply tells you how much a fund moves compared to its benchmark index. You must assess the inherent risks associated with the fund’s portfolio before making an investment decision. A mutual fund advisor can help you accurately assess the risk associated with potential investments so you can choose the one that suits you best.
Alpha vs Beta: Key Differences
Before we go any deeper into what is alpha and beta in mutual fund investments, you should know that you can only compare the alpha and beta of two funds within the same mutual fund category. That means you can’t compare the alpha and beta of a large-cap fund with that of a mid-cap or small-cap fund, as they have different risk profiles and benchmarks.
For example, comparing the alpha of a large-cap mutual fund to a small-cap mutual fund would be meaningless because small-cap funds have higher volatility and return expectations. Similarly, beta also varies across fund categories. For example, a small-cap fund would likely have a higher beta, as it tends to be more volatile than large-cap funds.
With that out of the way, check out some differences between alpha and beta in mutual funds:
| Factor | Alpha | Beta |
| Meaning | Alpha is a measure of a fund’s performance over or under the benchmark. | The beta coefficient tells us about how sensitive a fund is to market movements. It indicates how much the fund’s returns are expected to fluctuate in relation to its benchmark. |
| Ideal Values | An alpha above 0 suggests the fund has beaten its benchmark’s returns. For example, an alpha of 2.2 tells us the fund has generated 2.2% more returns than expected. The higher its value, the better. | A beta less than 1 indicates the fund isn’t very volatile, and its value above 1 suggests that the fund is more risky. The higher the beta, the more the fund can rise during market upswings (and also fall more during downturns) |
| How Is It Calculated? | The formula for alpha is based on the capital asset pricing model, which takes into account the fund’s returns, risk-free return, and beta. | Regression analysis is the primary way of calculating beta, where the fund’s returns are plotted against the benchmark index’s returns over a specific period. The slope represents the beta. |
| How Can It Be Used? | Investors can use alpha to assess whether the fund manager’s decisions have helped generate more returns compared to the expected returns or benchmark. | Beta can help investors understand and manage risk across different asset classes. |
Alpha and beta are just two of the many factors you should assess before investing in a mutual fund. To pick the most suitable funds, you must ensure they align with your financial profile. A mutual fund investment planner can help you understand and assess various technical aspects and guide you in selecting funds with strong fundamentals that match your risk tolerance, financial goals, and investment horizon.
How to Calculate Alpha and Beta in Mutual Funds
1. Alpha Calculation
Alpha can be calculated using the formula:
Alpha = Ri – (Rf + B * (Rm – Rf))
Where,
- Ri is the fund manager’s return,
- Rf is the risk-free return, which generally refers to the return of long-term government bonds,
- B is the beta, and
- Rm is the return of the benchmark index
2. Beta Calculation
Beta = Covariance (Ri, Rm) / Variance (Rm)
Here,
- Ri is the fund’s returns,
- Rm are the market returns,
- Thus Covariance (Ri, Rm) is used to measure how the fund’s returns move in relation to the market’s returns. A positive covariance means they move together, while a negative covariance means they move against each other.
- And finally, Variance (Rm) measures how much the market’s returns fluctuate over a period.
Now let’s look at an example to understand the process of calculation alpha and beta in mutual fund investments.
Practical Example: Alpha and Beta Calculation
Now let’s use the above formula to calculate the alpha ratio in mutual funds. Suppose the realised return of a mutual fund was 13%. In the same year, its relative benchmark returned 10%. Let’s say the fund’s beta against its index is 1.1, and the risk-free rate (G-sec) is 6%.
Alpha = Ri – (Rf + B * (Rm – Rf))
Here,
- Ri = 13%
- Rf = 6%
- Rm = 10%
- B = 1.1
Alpha = 13 – (6 + 1.1(10 – 6))
Alpha = 13 – (6 + 4.4)
Alpha = 2.6
This means the mutual fund outperformed its expected return by 2.6%!
Calculating the beta ratio in mutual funds is a bit more complex because it requires historical return data and statistical calculations. Generally, beta is calculated on software like Excel. Once the variance and covariance values are known, beta can be easily calculated using the formula Beta = Covariance (Ri, Rm) / Variance (Rm).
Why Alpha and Beta Matter in Mutual Fund Investing
There are good reasons why alpha and beta in mutual funds are considered essential metrics by investors. When you invest in an actively managed fund, it’s natural to expect the fund manager’s expertise to generate higher returns than simply investing in a passive index fund. The alpha can tell you whether it outperformed its benchmark after adjusting for risk. The higher the number, the more worth the fund manager’s decisions have added to your investment.
At the same time, you may want to gauge a fund’s volatility before investing. Beta can tell you how much a fund’s NAV movements correlate with the market. While a higher alpha is always desirable, beta interpretation is not as straightforward. Growth-oriented investors are attracted to higher beta funds as they promise the potential to deliver higher returns when the markets are up.
A lower beta would be more appealing to conservative investors who prioritise stability above all else. However, beta alone is not a good indicator of the absolute risk of a fund. It simply measures how much a fund moves relative to its benchmark. For example, a low-beta fund can still carry huge risks if it invests in volatile asset classes.
While these two metrics are important, understanding what is alpha and beta in mutual fund investments is not enough. Investors should also learn how other measures of performance and risk, like standard deviation, Sharpe ratio, Treynor ratio, Sortino ratio, and R-squared work to make well-rounded decisions.
Moreover, a variety of a mutual fund’s quantitative and qualitative aspects, such as its expense ratio, AMC, manager’s expertise, and consistency of returns should also be thoroughly analysed. Finally, make sure your choice lines up with your risk tolerance and financial goals. The best mutual funds are those which help you realise your financial dreams effectively and efficiently.
Conclusion
In investing, the principle of risk-return trade off states that the potential for higher returns comes at the cost of higher volatility, while lower volatility leads to lower returns. Simply put, if you want to earn higher profits, you must be willing to take on more risk, and if you prefer stability, you have to settle for modest returns. Alpha and beta are two measures that can be used to assess this trade off to a certain degree.
The alpha in mutual fund investments tells you whether or not a fund is outperforming its benchmark, and if the fund manager is adding value through active management. On the other hand, beta in mutual fund investments can help you gain insights into an investment’s volatility relative to the market. A higher alpha is always good, whereas a higher beta is only good when you are comfortable with higher risk and seeking higher returns.
Now that you know what alpha and beta are in mutual fund investments, remember that these two are not the only metrics to consider when evaluating a fund. Other factors like expense ratio, risk-adjusted returns (Sharpe, Teynor, and Sortino ratios), standard deviation, R-squared, and portfolio composition also play an important role in making well-researched investment decisions.
