What Is Alpha & Beta In Mutual Funds – Formula & How It Is Calculated

While investing in mutual funds, the two most commonly used parameters are Alpha and Beta. These are two of the most important tools used for measuring the performance and risk of a mutual fund with respect to a market index. Alpha is the value that a fund manager adds to or subtracts from the return of a fund compared to a benchmark index, while Beta is the measure of the sensitivity of the fund to the overall market movements. Thus, these metrics are critical for investors to evaluate a mutual fund’s performance and risk level. In this article, we will dig deeper into what Alpha and Beta are, their importance, how they are calculated, and how they can help in making informed investment decisions.

What is Alpha in Mutual Funds?

Alpha measures a mutual fund’s performance relative to a benchmark index, say the Nifty 50 or Sensex. It shows the excess return generated by the fund above the expected return, which is calculated on the basis of its Beta and market movements. In simple terms, Alpha tells you how much value the fund manager has added (or subtracted) by actively managing the portfolio.

Positive Alpha indicates that the mutual fund has outperformed the benchmark, which means that the fund manager has added value.

Negative Alpha means that the fund has underperformed the benchmark, which is an indication that the manager has not been able to achieve the return for the risk taken.

For instance, if a mutual fund has a 5% return while its benchmark index has delivered only 3%, the fund has an Alpha of +2. This suggests that the manager’s skill in picking investments has outperformed the market.

What is Beta in Mutual Funds?

Beta is a measure of the volatility of a mutual fund in relation to the market. It describes the extent how which returns from the mutual fund correlate with the larger market. A Beta value, therefore, reveals how risky a fund is and also the level of sensitivity a fund has to changes in the market.

Beta of 1 means that the movements of the fund are almost a mirror image of the market. If the market is up by 5%, the fund will likely go up by 5%.

Beta greater than 1 indicates that the fund is more volatile than the market. If the Beta is 1.5, it implies that the fund would most likely move 1.5 times as much as the market. Thus, the potential of getting both gain and loss will be higher.

A beta of less than 1 means that the fund is less volatile than the market. A fund with a Beta of 0.5 would only move 50% of the market’s movements.

Beta helps investors to evaluate the risk associated with a mutual fund. A higher Beta usually means more risk, while a lower Beta means low risk.

Why Are Alpha and Beta Ratios Important?

Alpha and Beta are the basic measures for evaluating mutual fund performance and risk. Each of these serves a different purpose; hence, here’s why they are important:

• Alpha gives a clear view of how well a fund is performing in relation to its benchmark. Alpha is said to be positive if the fund manager offers value added through his active management. Investors who want to invest in active management funds look for a fund with a consistently positive Alpha since it shows that the manager can outperform the market.

• Beta is an important measure in evaluating how a fund is risky compared to the average of the general market. An investor who will risk less prefers a beta value below 1 while taking on higher risks and will look for higher beta values. The meaning of beta is used to interpret the magnitude to which returns for the fund can swing as a function of prevailing market conditions.

Thus, a clear understanding of Alpha in mutual funds and Beta in mutual funds enables an investor to construct a better-balanced portfolio. For instance, conservative investors looking for a steady return would be interested in funds that have high Alpha but low Beta. On the other hand, a risk-tolerant investor may be drawn to funds that have a high Beta as he will be expecting more returns from it if the market rises.

How Are Alpha and Beta Calculated?

The calculation of Alpha and Beta is a statistical analysis, both of which are derived from historical returns. Here is how each is calculated:

Calculation of Alpha:

Alpha is calculated as the difference between the expected return based on Beta and the market’s return from the actual return of the fund:

Alpha = Actual Return of Fund – [Risk-Free Rate + Beta x (Market Return – Risk-Free Rate)]

Where:

Risk-Free Rate is the return on a risk-free asset, such as government bonds.

Beta is the measure of the fund’s sensitivity to market movements.

Market Return is the return of the market benchmark (e.g., Nifty or Sensex).

Beta Calculation:

The following formula calculates beta:

Beta = Covariance (Fund Returns, Market Returns) / Variance (Market Returns)

Where:

Covariance measures how two variables move together (in this case, the fund’s returns and the market’s returns).

Variance measures the degree to which the returns of the market deviate from its mean return.

In practice, Beta is calculated using any statistical software or even Excel, whereby one can plot the historical returns of the fund and the market against each other and apply regression analysis.

Conclusion

Alpha and Beta are valuable tools enabling investors to analyze mutual funds for performance and risk. Alpha measures the fund manager’s extra value added relative to the benchmark. In contrast, Beta helps investors understand if the fund is volatile and sensitive to market changes. By observing both, investors can choose mutual funds consistent with their risk tolerance as well as investment goals. In other words, Alpha emphasizes the return derived by the fund manager while Beta gives the measure of the risk undertaken by the fund in relation to the overall market.

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