Understand the Risk-Return Dynamics of Mutual Funds: A Practical Guide to Alpha and Beta

November 28, 2023 Mutual Fund

In the realm of financial investments, mutual funds have emerged as a popular choice for individuals seeking to navigate the complexities of the financial markets. These professionally managed investment avenues provide diversification, convenience, and access to a wide range of asset classes.

A significant number of new investors are entering the mutual funds arena through Systematic Investment Plans (SIPs) and lump sum investments.

However, before making an investment in mutual funds, investors may consider analysing various qualitative and quantitative parameters.While past performance is a valuable indicator of an investment’s potential, it’s crucial for investors to look beyond historical returns and delve into the fundamental metrics that underpin an asset’s risk and reward profile.

[Read: Relying on Star Ratings to Pick Best Mutual Funds? Read This]

Alpha and Beta, two key investment metrics, provide valuable insights into an investment’s ability to generate excess returns and its sensitivity to market fluctuations.

Moreover, understanding the risk-return dynamics of mutual funds is crucial for making informed investment decisions. Alpha and Beta are two important measures of risk in a mutual fund scheme. Both are calculated using the scheme’s return, benchmark return and risk-free return. Alpha measures the risk-adjusted returns of a mutual fund, while Beta indicates a fund’s sensitivity to market movements.

This article is a detailed guide to the concept of Alpha and Beta in mutual funds, their calculation, importance and interpretation.

What Is Alpha in Mutual Funds?

One of the most crucial indicators of a mutual fund’s overall performance is its alpha. It represents the excess return of a mutual fund compared to a benchmark index, such as the S&P BSE 500 or the Nifty 50 index.

A positive alpha indicates that the fund has outperformed the benchmark, while a negative alpha indicates underperformance. Alpha is calculated by subtracting the risk-free rate, typically represented by the yield on government bonds, from the fund’s return and subsequently adjusting for the fund’s beta.

Moreover, the alpha in mutual funds is a crucial metric for evaluating the skills of a fund manager or the effectiveness of an investment strategy to generate substantial returns.

[Read: Are Your Equity Mutual Funds Generating Alpha Returns?]

What is Beta in Mutual Funds?

The volatility of a mutual fund’s performance in relation to the overall market is measured by its beta. To put it simply, beta is a statistic that compares a mutual fund’s sensitivity to changes in the market to that of the benchmark index it is based on.

When the beta of a fund is 1, it means that its returns should follow the market; when the beta is higher than 1, it means that the fund’s returns are expected to be more volatile than the market.

On the other hand, a beta of less than one suggests that the returns on the fund will probably be less erratic than those of the market. Accordingly, a mutual fund’s beta indicates how stable its performance was amid volatile market conditions.

[Read: How Mutual Funds Are Deploying Cash in Volatile Equity Markets]

The Relationship between Alpha and Beta

Alpha and Beta are not mutually exclusive; they provide complementary insights into a fund’s risk-return profile. A fund that exhibits both high alpha and high beta indicates that it bears a higher level of risk and has the potential to yield substantial rewards. Conversely, a fund with low beta and low alpha may have reduced volatility in addition to offering decent returns.

Investors can make wise choices about their mutual fund investments by comprehending the relationship between alpha and beta.

Now, let’s examine the process for determining the Alpha and Beta.

How to Calculate Alpha and Beta in Mutual Funds?

Alpha in mutual funds can be calculated with the following formula:

Alpha = (Mutual fund return – risk-free return (RF)) – [(Benchmark return – risk-free return (RF)) x Beta]

Alpha can be calculated alternatively by using CAPM (Capital Asset Pricing Model). As CAPM is indicative of the expected returns from a specific fund, any figure that differs from the same is the alpha.

Interpretation of Alpha:

The baseline for the alpha in a mutual fund is zero. When a mutual fund’s alpha is negative, it means that it has underperformed the benchmark index. Additionally, it shows how poorly the fund manager performed.

If the alpha in a mutual fund is positive, it indicates satisfactory performance on the part of the fund manager. It indicates that the fund is performing better than the underlying benchmark index. If the alpha is zero, the mutual fund aligns with the benchmark index.

Although a higher alpha value may denote higher returns, but this is not the only criterion investors may consider while making investment decisions.

[Read: Looking to Generate Alpha Over the Long-term?…]

Beta in mutual funds can be calculated with the following formula:

Beta = (Mutual fund return – risk-free rate (RF)) / (Benchmark return – risk-free rate (RF))

A mutual fund’s beta indicates how it reacts to changes in the market. Put differently, it indicates whether the returns on an investment fund rise or fall in tandem with the market.

Interpretation of Beta:

For benchmark indices, one is always the baseline. A mutual fund’s higher degree of volatility is indicated by a beta value greater than one. This means that the fund is more sensitive to the changes that happened to the benchmark index.

If the beta value is less than one, the mutual fund is less sensitive and shows fewer deviations compared to the benchmark index.

Let us Look at an Example…

Assuming a risk-free return of 10%, the beta in the case of a mutual fund scheme that generates returns at 20% p.a, while the benchmark index offers 15% p.a would be:

Beta= (20 – 10) / (15 – 10) = 2

This indicates that the mutual fund is two times as volatile as the benchmark index.

Now, let’s calculate the alpha assuming the same figures as above.

Alpha = (20 – 10) – [ (15 – 10) x 2) = 0

If we assume beta is 1, Alpha = (20 – 10) – [ (15 – 10) x 1) = 5

This means that the scheme is in line with the benchmark index in the first case, where the alpha is at zero. In contrast, the second scenario, where beta is 1, shows that the fund has outperformed the benchmark index.

These calculations may seem complex. But you can always reach out to a SEBI-registered financial advisor to get more clarity on alpha and beta. An investor doesn’t need to understand these complex calculations; one may strive to comprehend the interpretation and evaluate the alpha and beta ratios alongside past performance when choosing a mutual fund.

[Read: Mutual Funds Are Betting Big on These Sectors: Are You Missing Out?]

How Investors may approach Alpha and Beta in mutual funds?

When evaluating alpha and beta, it is important to consider the specific investment objectives and risk tolerance of the investor. A fund with a high alpha and beta may be appropriate for investors who are ready to take on high risk in exchange for high potential returns.

However, a fund with lower alpha and beta can be more suitable for conservative investors who prioritise consistent returns and lower risk. It is crucial to recognize that alpha and beta are historical measures and may not accurately reflect a fund’s future performance.

Market conditions and the fund manager’s strategies could significantly impact a fund’s risk-return profile over time. As a result, investors should consider the long-term track record of a fund’s alpha and beta before making an investment decision.

While alpha and beta provide valuable insights into a fund’s risk-return characteristics, they are not the only factors to consider when assessing a mutual fund. The fund’s investment objective, expense ratio, and fund manager track record are additional crucial factors to take into account.

In conclusion, alpha and beta are essential metrics for understanding the risk-return dynamics of mutual funds. Investors could make informed decisions by evaluating the alpha and beta alongside the past performance of a mutual fund scheme.

This comprehensive approach allows investors to strike a balance between potential rewards and acceptable risk levels, aligning their investment decisions with their risk tolerance and financial goals.

This article first appeared on PersonalFN here