Every little piece of information makes you smarter, which is good, because it pays to be smart. There are a lot of things you learn that you may never use again, but most things, like two little things called Alpha and Beta, can be extremely useful.
Two such quantitative measures of fund performance that you can use to improve your mutual fund investments are Alpha and Beta. Allow us to introduce you to them.
Let’s start with Beta. It measures thevolatility or the systematic risk of a Mutual Fund. Beta measures the fluctuation in periodic returns in a scheme, as compared to fluctuation in periodic returns of a diversified stock index over the same period. It tells you how a fund’s Net Asset Value (NAV) might vary for every change in the fund’s benchmark—a market index with similar underlying stocks/bonds as the Mutual Fund. For example, the BSE Midcap index is an appropriate benchmark for aMidcap Equity Fund. Similarly, Nifty Metal Index is an appropriate benchmark for a Sectoral Fund that focuses on Metal stocks.
A Mutual Fund’s Beta can be equal to, greater than or less than 1. A Beta of 1 means that the fund’s NAV is likely to replicate the movement in the benchmark or the market. If the Beta is less than 1 it means the NAV of the fund experiences milder price swings than the benchmark while if it is more than 1 it means the fund’s NAV swings more severely than the benchmark.
If a Mutual Fund’s Beta is greater than 1, its NAV is likely to exceed the change in the market index. A fund with Betabelow 1is likely to rise or fall less than the change in the value of its benchmark.
Making the best use of Beta
High Beta funds are more volatile than the benchmark.They tend to beat the benchmark when itgoes up, but they also fall more than the benchmark when itcomes down. This makes them relatively risky investments.
You may pick high Beta funds if your objective is to maximize your gains andare also prepared to bear big losses.Go for low Beta funds if you are satisfied with modest returns, but want your capital to remain safe.Beta as a measure of risk is relevant only for equity schemes.
Know what you are getting into using Beta
You can also use Beta to calculate the expected return on your Mutual Fund, given its risk profile.This can be done using the Capital Asset Pricing Model (CAPM). This model calculates the expected return using the risk-free rateand the risk premium.
If the term ‘risk-free rate’ caught your attention, read on. The risk-free rate is the rate of return on an asset that has no real risk of default.
Everything comes with a risk. So, we take something that has almost zero risk—government bonds. This is because the government is least likely to default on its bonds.All other issuers of financial instruments can potentially default.
You take this risk-free rate, and using the Beta (the riskiness of the asset), you ask for extra returns. This is because investors expectto be paid more than the government bond yield as acompensation for this risk.This extra return is called your risk premium.
Calculating the risk premium
A fund’s risk premiumis calculated as its Beta multiplied bythe risk premium of its benchmark. If a fund’s Beta is 1.2 and the risk premium forits benchmark is 2%, the risk premium for the fund will be 2.4% (i.e. 1.2 x 2%). This means that investors would expect the fund to generate at least 2.4% additional return over the government bond as compensation for assuming additional risk.
This risk premium is added to the risk-free rate to arrive at the fund’s expected return.
A Mutual Fund’s actual returns can differ from its expected returns. In other words, a fundcan generatehigher or lower returns than its risk profile justifies. The difference between a fund’s actual and expected returns is called its Alpha or its ‘surprise returns’.
The difference between a scheme’s actual return and its optimal return is its Alpha – a measure of the fund manager’s performance. Alpha is a measure of a fund manager’s ability to generate returns for their clients. A positive value of Alpha means that the fund has performed better than it was expected to, given its risk profile. This is a credit to the fund manager.
A negative Alpha means that the fund has not been able to generate enough returns to justify its risk profile.The fund’s investors may have been better off investing directly in the benchmark.
Smart investing is all about understanding your risk tolerance and selecting funds that seeks to maximize your returns, without additional risk.
Alpha-Beta is a great combination of tools that you can use to pick the correct Mutual Fund. Use Betato weed out funds that don’t suit your risk appetite. Then, use Alpha to pick the highest paying Funds out of the ones that remain.
Mutual Fund investments are subject to market risks, read all scheme related documents carefully.