Measuring Alpha & Beta: Mutual Fund
Investment can be an overwhelming task for an investor as there are various factors to consider before investing in any security. The factors that we consider include returns, risk, assessing risk appetite of the investor, goals, needs, etc. Therefore, to measure various risk and return parameters, ratios are used such as alpha, beta, Sharpe ratio (For detailed understanding, do refer: https://www.dsij.in/DSIJArticleDetail/ArticleID/19340/ArtMID/10163/preview/true), P/E ratio, R square, and standard deviation. Each of them depicts different aspects of risk and return like standard deviation measures risk, Sharpe ratio measures, risk-adjusted returns, etc.
Beta measures the volatility related to the benchmark while alpha measures the overall return as compared to the benchmark, etc. Now, we will look at Alpha & Beta in a detailed manner in this article.
What is Alpha & Beta?
Alpha measures the performance of a fund manager. It measures the returns over & above the benchmark and demonstrates whether the fund is outperforming or underperforming its benchmark. The baseline of alpha is 0. Positive alpha i.e. alpha greater than baseline shows the outperformance of the fund against the benchmark while negative alpha i.e. alpha lower than the baseline shows the underperformance of the fund against the benchmark. Likewise, if alpha is at par, then returns are in line with the benchmark.
Following is the formula of Alpha:
Alpha= Actual rate of return – Expected Return
Expected return= Risk free rate of return – Beta*(Market rate of return- Risk free rate of return)
For instance, if the return of any mutual fund scheme is 9 per cent against the benchmark of 7 per cent, here the alpha is 2. Therefore, this mutual fund scheme is outperforming against the benchmark by 2 per cent. Likewise, if the return of any mutual fund scheme is 7 per cent against the benchmark of 9 per cent, here the alpha is -2. Therefore, this mutual fund scheme is underperforming against the benchmark by 2 per cent.
Beta is the measure of volatility in mutual funds schemes relative to its benchmark. The baseline of beta is 1. If beta is more than 1, then mutual fund scheme is highly volatile than its benchmark whereas if the beta is lower than 1, then the mutual fund scheme is less volatile than its benchmark. Likewise, if the beta is 1, then the market is equally volatile as the benchmark. Investors with lower risk appetite will prefer beta lower than 1 whereas, investors with higher risk appetite prefers beta higher than 1. Beta is also used to calculate expected return using capital asset pricing model (CAPM) i.e. expected return. Following is the formula of Beta:
Covariance shows how the co-movement between the two stocks react to each other during different market conditions. On the other hand, variance is the square of standard deviation.
Investors shouldn’t only consider these two parameters before investing but also, other parameters along with the past performance of the fund.
The following graph depicts the average Alpha and Beta of equity-oriented mutual fund: