Alpha and Beta in Mutual Funds

Risk and return are two sides of the same coin. For any investment, risk and return co-exist. Unless you take the risk, you cannot expect high returns. However, the high risk doesn’t always guarantee high returns. The probability of losing your corpus is also high. While shortlisting any investment, you should be able to understand the risks and also the risk-adjusted returns. Similarly, while evaluating a mutual fund, establish an understanding of the risk and returns. This article covers types of risk, what is alpha and beta in mutual funds, how to calculate them, and their importance in mutual funds.

What is Risk for Alpha and Beta Calculation?

Risk, from a technical point of view and for the purposes of measurement, is the variance from expected or average returns. The most popular metric to measure risk is the standard deviation. It is a statistical metric that measures the deviation of returns from average returns.

Alpha and Beta are the two most important metrics for ascertaining the risk in a mutual fund. Both the ratios consider the mutual fund return, benchmark return and risk-free return. A risk-free return is a return you can expect from an investment without taking any risk.

Alpha measures the risk-adjusted returns of a mutual fund. At the same time, beta indicates the sensitivity of a fund to market movements.

How is Risk Measured?

In finance, risk is considered the probability of losing some or all of the investment corpus. Different mutual funds have different levels of risk. As a result, it is the risk factor that influences the choice of funds.

Risk arises from different sources – internal and external. Though it’s difficult to track all the risk sources, it is easy to measure risk. There are different risk evaluating metrics that you can leverage to measure risk.

Following are some of the popular risk measuring metrics:

• Standard Deviation: Standard deviation indicates the riskiness of a fund. In other words, it shows the deviation in the accrual returns from its mean (average returns).
• Alpha: Alpha measures the risk-adjusted return of a mutual fund. It helps you assess the performance of a fund against its benchmark.
• Beta: Beta is a risk metric that analyses the relative volatility of a mutual fund’s performance in comparison to the market/ benchmark. As a result, beta just considers the fund’s sensitivity; it does not consider the inherent risk.
• R-Squared: R-Squared measures the correlation between the fund and its benchmark performance. It is measured on a scale of 100. R-Square of 100 indicates that the fund’s performance perfectly correlates to its benchmark.
• Sharpe Ratio: Sharpe ratio measures the risk-adjusted returns of a mutual fund. This ratio considers the fund returns, risk-free returns and the standard deviation.
• Sortino Ratio: Sortino ratio also measures the risk-adjusted returns of a mutual fund. However, it considers only the downside of the standard deviation.

Explore Standard Deviation in Mutual Funds

How is a Risk-Free Return Measured?

A risk-free return is a return you can get without taking any risk with your investment. Risk translates to any market risk, interest rate risk, credit risk, or unsystematic risk. It is the interest that you can expect from a risk-free investment over a period of time.

Every investment has a certain amount of risk attached to it. Practically, there are no investment schemes that are 100% risk-free. However, the yield of treasury bonds is considered a standard risk-free rate. The risk-free rate in India is the 10-year government bond yield rate.

To compute the real risk-free return, you should subtract the inflation rate from the 10-year government bond yield.  

How is a Risk-Adjusted Return Measured?

You should always consider the returns an investment generates and also the amount of risk it takes to earn these returns. Risk-adjusted return helps you measure both. It revolves around the concept of calculating an investment’s return by looking at how much risk is taken to get the return.

Sharpe ratio is a popular metric for measuring risk-adjusted return. The Sharpe ratio is the ratio of the fund’s excess returns over the risk-free rate to the fund’s standard deviation. However, the Sharpe ratio doesn’t indicate whether the volatility is good or bad and has certain limitations.

On the other hand, the Sortino ratio is similar to the Sharpe ratio, although Sortino considers the downside of the volatility. In other words, volatility in the down markets.

Both Sharpe and Sortino ratios do not distinguish between the market risk and excess risk over the market. However, Alpha addresses this. Alpha is the measure of outperformance of a fund over its benchmark. It also tells if the outperformance is due to higher risk taken by the fund or the fund manager’s ability to generate superior risk-adjusted returns.  

What is Alpha and Beta in Mutual Funds?

Alpha

Alpha is a metric that helps you assess a fund’s performance against its benchmark. It is a measure of risk-adjusted return.

For mutual funds, the Alpha baseline is 0. If alpha is 0, it means that the fund has given the same returns as that of the benchmark. If alpha is less than 0 (negative), it means that the mutual fund has underperformed its benchmark. On the other hand, if alpha is greater than 1, the fund has outperformed the benchmark.

Let’s understand this with an example. Suppose you invest in a Mutual Fund A, and its benchmark is NIFTY. Let’s assume the return from NIFTY has been 25% in a year. And the Alpha of your fund is 4. This indicates that mutual fund A has outperformed the benchmark by 4%. The return from the fund is 29% for the same year.

Similarly, if the fund’s alpha is -2, it means that the fund has underperformed its benchmark by 2%, and the returns from the scheme are 23%.

Alpha helps you assess the efficiency of the fund manager as well. Simply put, you can assess the fund manager’s value. Therefore, higher returns and greater alpha indicate the fund manager’s efficiency in curating the right investment portfolio.

Beta

On the other hand, beta indicates the sensitivity of a mutual fund towards market movements. It’s a metric for how volatile a mutual fund portfolio is in relation to the market. When you analyse the beta of a mutual fund, you’re trying to understand the fund’s return with respect to market ups and downs. The market in this context refers to the fund’s benchmark index.

The market’s or benchmark’s beta is always 1. In comparison to the benchmark index, a beta of less than 1 indicates lower volatility. While a beta greater than 1 indicates high volatility.

Let’s understand this with the above example. The beta for mutual fund A is 0.8. It denotes that the fund has lower volatility when compared to the market. Simply put, when the market falls by 1, the fund falls only 0.8. Similarly, if the market rises by 1, the rise in the fund will be 0.8. Often investors with low to moderate levels of risk should prefer funds with lower beta.

Though beta provides insight into an asset’s relative riskiness. It does not provide insight into the asset’s inherent or absolute risk.

How To Calculate Alpha and Beta in Mutual Funds?

To compute alpha and beta, you need to understand the Capital Asset Pricing Model (CAPM) formula. The CAPM establishes a relation between the fund returns and the market risk. Using the CAPM formula, you can easily compute the beta value.

Mutual Fund Return = Risk-Free Rate (R_f­) + Beta * (Benchmark Return – Risk-Free Rate (R_f­))

Rearranging the above equation will give you the formula for the beta.

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

Another formula for Beta is

Beta = Covariance / Variance

Covariance shows how two different funds vary from one another under different market scenarios or conditions. On the other hand, variance depicts how the fund’s price differs from its average price. It also explains how volatility in the fund’s price changes over time.

Alpha = (Mutual Fund Return – Risk Free Return (R_f­)) – [(Benchmark Return – Risk Free Return (R_f­)) * Beta]

Let’s understand how to compute alpha and beta with an example. Suppose a mutual fund A gives a 10% return in a year, and its benchmark gives an 8% return for the same duration. Assuming the risk-free rate to be 5%.

Beta = (10 – 5) / (8 – 5) = 1.67

Therefore, this indicates that the fund is highly volatile.

Taking the same example, if a fund’s beta is 0.75, let’s see its alpha value.

Alpha = (10 – 5) / [(8 – 5) * 0.75) = 5 – 2.25 = 2.75

Alpha value of 2.75 indicates the fund’s outperformance.

What is the Importance of Alpha and Beta in Mutual Funds?

While shortlisting any investment scheme, it is always advisable to look at the historical returns of the scheme. Similarly, while choosing a mutual fund, you should look at the past performance of the scheme. Though past performance does not guarantee future returns, it is a good indicator to assess the fund manager and his performance during different market conditions.

The metrics alpha and beta are useful to compare a mutual fund’s performance to its benchmark. Furthermore, these values help evaluate potential growth, risk, volatility, etc.

For investors, alpha is a valuable metric for deciding if a mutual fund is worth investing in because it gauges the fund manager’s ability to make profits. As a result, you can make an informed investment decision based on the fund manager’s performance.

Furthermore, beta helps in assessing a fund’s sensitivity to market movements. You can determine whether or not a mutual fund is suitable for your risk profile by looking at its beta.

Risk-averse investors often prefer a low beta since it indicates consistent returns and has low volatility. On the other hand, investors seeking significant returns can consider funds with a beta greater than 1.

How To Interpret Alpha and Beta in Mutual Funds?

Alpha

Alpha measures how much return you can expect from your mutual fund return. When you look at the Alpha value of a mutual fund, you can estimate how much return can make.

A higher Alpha value can indicate higher returns; however, it isn’t the sole metric that helps you assess a fund’s performance.

When studying returns with the Alpha, there are various challenges. It shows how well a fund performs in comparison to the market’s benchmark index. Different markets, on the other hand, have different benchmarks. Therefore, while investing in a fund, ensure that you do proper research about the market as well.

If the alpha of a fund is 5 and the benchmark return is 15%, this indicates that the fund has outperformed its benchmark by 5%. The overall return for the fund is 20%. Similarly, if the fund’s alpha is -5, it indicates that the fund has underperformed its benchmark by 5% and the fund’s return is only 10%. On the other hand, Alpha 0 indicates that the fund manager was unable to outperform the benchmark index.

Beta

Beta measures the sensitivity of a fund to market conditions. Using the value of beta, you can determine whether or not to include the fund in your investment portfolio. Risk-averse investors should prefer funds with a beta less than 1, while risk-takers can opt for funds with a higher beta.

The Fund’s beta of more than 1 indicates that the fund is highly volatile and is more responsive to market movements. When the beta is less than one, the fund is said to be less volatile to the market scenarios.

Furthermore, a beta of 1 indicates that the fund is responding to the market movement equivalently as its benchmark.

Taking an example of a mutual fund with a beta of 0.7 indicates that the fund is 30% less volatile than its benchmark. In contrast, if the beta is 1.5, it indicates that the fund is 50% more volatile than its benchmark.

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