Alpha and Beta in Mutual Funds: Meaning, Importance & Calculation

When it comes to funds, “alpha” is a performance measure that assesses how well the fund manager can generate returns compared to either the fund's benchmark index or the broader market. It serves as an indication of the manager’s expertise in selecting securities and making investment choices that result in outperformance versus a benchmark index such as Nifty 50 Index or Nifty Small Cap 250 Index. Typically, alpha is represented by a single number that can be either positive or negative. An alpha of zero means that the mutual fund provides the same returns as the benchmark index.

The benchmark index represents the performance of the market.

• If a mutual fund achieves alpha, it means that it has outperformed the benchmark, suggesting that the fund manager's management and investment strategies have successfully added value for the fund’s investors.
• Conversely, if a mutual fund has not achieved alpha, it indicates underperformance compared to its benchmark. This suggests that either the fund manager’s decisions did not generate higher returns than the benchmark so did not justify risks or fees charged by the fund.

In mutual funds, "beta" serves as a gauge of a fund's susceptibility to the changing conditions of the broader equity market.

Traditionally, a mutual fund benchmark index can be one like the Nifty Smallcap 250 Quality 50 Index. This index, by definition, can be considered to have a beta of 1. A mutual fund with a beta equal to 1 implies that the fund’s performance correlates exactly to the chosen benchmark. If the market moves upwards by 10%, the fund will give an equivalent return of 10% during the same time period.

• If a mutual fund has a beta exceeding 1, like say 1.2, performance of the fund will deviate more than the benchmark index. This signifies that the scheme is more volatile than the benchmark. So, the fund can generate greater returns than the market during bullish periods, yet it may also endure higher returns during bearish periods.
• Conversely, if a mutual fund carries a beta less than 1 e.g. 0.8, it is recognised as less correlated to the performance of the benchmark. It tends to offer superior downside protection in comparison to the index, even though its returns may not mirror the market's performance during sustained bull runs.

Below is the alpha calculation formula using the CAPM method that one can use:

Alpha = (End Price – Start Price + DPS) / Start Price

Where, DPS signifies Distribution per Share

Alternatively, CAPM (Capital Asset Pricing Model) provides an effortless method to calculate the alpha of a mutual fund. CAPM predicts the expected returns from a mutual fund, and any deviation from this value represents the alpha.

For instance, if a fund's CAPM predicts an 8% return, but it actually achieves a 12% return, the difference indicates that the asset manager generated 4% higher returns than expected. Therefore, the alpha value amounts to 4.

The beta of a mutual fund can be calculated using the below formula:

Beta = Covariance / Variance

In the above beta calculation formula of mutual funds, covariance demonstrates how the performance of the fund can vary significantly from its index in diverse market situations. On the other hand, variance is a data that shows fluctuations in a fund's price over time compared to its average price during a specific period.

Here are the reasons alpha and beta matter in mutual funds:

• Alpha helps investors in determining whether a fund manager is effective at outperforming the market. It reveals the manager's stock selection and timing expertise.
• Beta informs investors about the volatility of a mutual fund in comparison to the larger market.
• Understanding a mutual fund's beta can assist investors in diversifying their portfolios by determining how much risk they are exposed to while investing in the fund. Combining assets with varying beta levels might help lower the overall portfolio risk.
• Investors can utilise alpha and beta to select mutual funds that match their risk tolerance and investment goals. Conservative investors may prefer low-beta funds, but those looking for bigger returns may be ready to invest in higher-beta funds.

Mutual fund ratios, alpha, and beta, actively gauge risks and volatility. These ratios factor in benchmark yields, specific scheme yields, and risk-free yields to compute risks. This is why they matter in fund selection.

Here's how alpha and beta are used to evaluate risks in mutual funds: