What is Alpha and Beta in Mutual Funds

Rohan scored 45 marks, while Vinay scored 80. Does that tell you who is a better performer? Actually, it does not, unless you know the benchmark score for both of their scores. And that is where investors get mislead in the chaotic world of mutual funds. 

The two most commonly used instruments in the financial markets - alpha and beta - quantify the performance, response, and interaction of mutual funds in the market. 

If I tell you that Rohan scored 45 marks, the information may or may not give you any idea about Rohan's performance in the class, unless you are told whether the score is out of 50 or out of 100. The maximum score, in such a case, acts as a benchmark, against which Rohan's score can be evaluated. 

It is, however, not necessary that the maximum score may be the only possible benchmark. The benchmark could also be the highest score or the average score in the class. Such a benchmark makes it more relevant in case the examination was tough. Whatever be the benchmark is another point of discussion, but the absence of a benchmark gives us no idea about the performance.

The same goes for mutual funds. How do we judge the performance of any particular fund in a specific category? We need a benchmark. So, here comes the concept of something popularly called the Benchmark Index.

What is the Benchmark Index?
Before we go on to understand alpha and beta, we ought to understand an important term i.e. benchmark index

A benchmark is an index that sets the standard against which performances of securities, funds, etc. are measured. Different types of securities will obviously have different benchmarks.

What is Alpha?
A fund returning 20% looks good. But think again. Is it really good? If all funds of the same category (say equity Mid-Cap category) are returning 30% returns, then would you still rate the fund returning 20% as a good fund to invest in? Probably no. Therefore, just numbers cannot tell us the entire picture.

That is precisely where we need the support of a tool like Alpha.

Alpha represents a fund's performance in comparison to the benchmark index. 

• The baseline for alpha in Mutual Funds is 0.
• A figure of 0 in the case of alpha is indicative of an asset manager’s performance graph to be precisely in line with the benchmark index. 
• Any number in the negatives would suggest the asset manager’s performance as underwhelming. 
• Further, alpha in mutual funds beyond 0 showcases the fund manager’s achievement of outperforming the benchmark index.
• A high alpha is always good.
• A positive alpha of 1.0 means the fund or stock has outperformed its benchmark index by 1 percent. A similar negative alpha of 1.0 would indicate an underperformance of 1 percent.

What is Beta?
Rohan scores 45, Vinay scored 80. Both scores were out of the benchmark score of 100. Though Vinay's performance is undoubtedly better than Rohan's, does that make Vinay a better performer in the long run? What if this was a one time fluke by Vinay, and in general, Vinay has been completely unpredictable in his scores - many times scoring less than Rohan. So, consistency or stability is another vital factor that needs to be accounted for, before investing our money.

Talking about mutual funds, a fund returning 20% is good if it has a positive alpha. But when one is in the market, returns may not be the only criteria. The stability of returns over a period of time is also vital. 

Beta registers and quantifies a fund’s response to market volatility, i.e. the degree of conformity of a fund’s prices in response to any change in the benchmark index. 

• The baseline for beta in Mutual Funds is 1.
• In the case of beta, value 1 suggests that a specific fund responds to market volatility equivalently, i.e. the shift in its price is equivalent to the benchmark movements. 
• A value above 1 represents that a specific fund demonstrates a more significant shift in its price compared to benchmark movement i.e. more volatility.
• A value below 1 represents the opposite i.e. more stability.
• A high beta may be preferred by an investor in growth stocks but shunned by investors who seek steady returns and lower risk.
• A high beta means the stock price is more sensitive to news and information and will move faster than a stock with a low beta. In general, high beta means high risk, but also offers the possibility of high returns if the stock turns out to be a good investment.

What are the other indicators of performance?

Alpha and Beta are not the only measures of performance. There are five main indicators of investment risk that apply to the analysis of stocks, bonds, and mutual fund portfolios. Alpha and Beta are the most fundamental. Others include r-squared, standard deviation, and the sharpe ratio. These statistical measures are historical predictors of investment risk/volatility and they are all major components of modern portfolio theory (MPT). 

These measurements, along with alpha and beta are employed to determine which fund is statistically performing better compared to its peers. 

Why should you look at alpha and beta?
Before choosing to invest in any mutual fund, it is imperative to know its past performance. However, you should note that past performance is in no way going to influence future performance. Nevertheless, it is always advisable for anyone to look at the past performance so that you know the fund manager and his performance over the different market phases. 

Some examples to understand alpha and beta
Consider the large-cap category of mutual funds, and let us consider the performance of Axis Blue Chip Fund

• The benchmark for this fund is BSE 100 TRI. The performance of this fund will be measured against this benchmark.
• The Alpha for this fund is 5.13, which indicates that it has been outperforming the benchmark index with as much as 5.13% higher returns. This is actually an astonishing high Alpha and is not very common.
• The Beta for this fund is 0.77. It means that it is 23% less volatile compared to the fluctuations in its benchmark, indicating very high stability of returns.
• This combination of a high Alpha and low Beta is a perfect combination to go ahead and invest your hard-earned money.

Conclusion

Investors must look for alpha and beta of a mutual fund before they decide to invest in it. These ratios help them in understanding how well a fund has performed over different market cycles.

Regards

Manoj Arora
Official Website