Alpha and beta are two of the most commonly used parameters to measure the performance of investment vehicles that are linked with financial markets. In mutual funds, alpha and beta measure the performance, response and relation with the equity markets. We have covered the following in this article:
Apart from alpha and beta, there are numerous other parameters used to measure the performance of one mutual fund with another or index.
1. What is Alpha?
Alpha measures the performance of an asset manager. It measures the efforts put in by a fund manager in driving the fund that he or she is managing as against a benchmark index. Alpha’s baseline is 0 in case of mutual funds. If alpha is negative, then it indicates that the performance of the fund manager was underwhelming. If alpha is positive, then it suggests that the fund manager’s performance was overwhelming. Generally, the performance of a mutual fund is compared with that of an index.
2. What is Beta?
Beta is a measure of variations showed by a mutual fund when there is a fluctuation in a benchmark index. In simple words, beta is a measure of the sensitivity shown by a mutual fund to a movement in a benchmark index. Beta can be used to check how stable a mutual fund was when the markets were volatile. Beta’s baseline is 1 in case of mutual funds. If beta is 1, then it indicates that the mutual fund is showing the same variation as that of the benchmark index. If it is more than 1, then it suggests that the value of the fund changes in a much-pronounced manner when compared to the benchmark. If beta is less than 1, then it means that the variation in the fund value is lesser when compared to the benchmark index.
3. Importance of 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. Alpha and beta are tools that help in comparing the performance of a mutual fund against the benchmark. Furthermore, these ratios help in having important data to evaluate probable growth, risk, and sustainability to volatility, and so on.
For investors, alpha is useful in determining if a mutual fund is worth investing as it measures the capabilities of the fund manager to generate profits. Therefore, knowing how the fund manager has performed, they can make an informed decision. Likewise, beta helps investors in understanding how sensitive the mutual fund was when the markets went volatile. By checking beta of a mutual fund, the investors can decide if the fund that they are deliberating to invest in is suitable or not.
Risk-averse investors would like to have the beta on the lower side as it is indicative of steady returns and response to market volatility. Investors looking to invest purely to get high returns would like to see alpha always above 1.
4. Calculation of Alpha and Beta
The following is the formula to calculate alpha in the case of mutual funds:
Alpha = (End Price – Start Price + DPS)/Start Price
Here, DPS is the distribution per share
The following is the formula to calculate beta in the case of mutual funds:
Beta = Covariance/Variance
Here, covariance is indicative of how two different stocks vary from one another in different market condition. The variance shows the variation of a fund’s price from its average and represents the fund’s volatility in its price over a period.
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. Apart from alpha and beta, investors may also consider other parameters such as standard deviation, Sharpe Ratio, P/E ratio, and R-square.