In the financial market, the two most commonly used instruments are alpha and beta. These instruments quantify the performance, response, and interaction of a Mutual Fund in the stock market.
There are several other measures or methods instrumental in gauging a fund’s performance, namely Standard Deviation, Sharpe Ratio, P/E Ratio, and R-Square. These measurements, along with alpha and beta are employed to determine which fund is statistically performing better compared to its peers.
Alpha represents an asset manager’s performance in guiding a fund into yielding profits in comparison to the benchmark index. Beta, on the other hand, registers and quantifies a fund’s response to market volatility, i.e. the degree of conformity of a fund’s prices in response to any change in the benchmark index.
A benchmark is an index that sets the standard against which performances of securities, funds, etc. are measured.
The baseline for alpha in Mutual Funds is 0.
A figure of 0 in the case of alpha is indicative of an asset manager’s performance graph to be precisely in line with the benchmark index. Any number in the negatives would suggest the asset manager’s performance as underwhelming. Further, alpha in mutual funds beyond 0 showcases the fund manager’s achievement of outperforming the benchmark index.
The baseline for beta in Mutual Funds is 1.
In case of beta, value 1 suggests that a specific fund responds to market volatility equivalently, i.e. the shift in its price is equivalent to the benchmark movements. A value above 1 represents that a specific fund demonstrates a more significant shift in its price compared to benchmark movement. A value below 1 represents the opposite.
Why Alpha and Beta Ratios Important?
When selecting a Mutual Fund to invest in, whether it’s a capped fund, ELSS, or etc., it is paramount to gauge its past performance to make informed decisions for investing.
Ratios are an essential tool in determining a fund’s history against different market phases. It also helps produce substantial data to reckon its prospects in the future – growth potential, sustainability, risk factor, etc.
Although these predictions might vary from actual results, it still provides a significant picture to the prospective investor for his/her decision.
The alpha ratio in Mutual Funds is valuable to an investor as it helps him/her to determine whether an asset or fund is worth pursuing depending on the asset manager’s capability to earn profits.
For example, if an asset manager can reap a 10% return on a specific Mutual Fund against a benchmark index of 8%, his/her alpha ratio would be 2. Investors opt to invest as per the alpha ratio in Mutual Funds around 1.5. Note that the alpha ratio in Mutual Funds should be considered based on a mean of previous performance and not just on current data.
Similarly, a beta ratio in Mutual Funds offers investors the data on the degree of the volatility a Mutual Fund displays in response to market fluctuations. An investor can determine which fund would be best suited to meet his/her financial objectives.
Suppose, the beta ratio of a specific Mutual Fund is 0.7 or 70%; it means the fund is 0.3 or 30% less volatile than the benchmark index. A Beta ratio value of 1 indicates a lower risk and lower growth potential compared to ratios at par or above 1.
Investors with a low-risk appetite would always prefer a lower beta ratio in Mutual Funds as it indicates a steadier response to a volatile market condition. Similarly, investors with the investment objective of higher returns would prefer beta ratios of 1 or more than 1.
Beta is also a significant factor when gauging the Capital Asset Pricing Mode or CAPM. It denotes the expected rate of returns of an asset or fund. This data aids investors to decide whether to include a specific fund in the investment portfolio or not.
Calculation of Alpha and Beta Ratios in Mutual Funds
The alpha Mutual Funds formula is (End Price + DPS – Start Price)/Start Price.
Here, DPS is Distribution per share.
Alpha can be calculated alternatively by using CAPM. As CAPM is indicative of the expected returns from a specific fund, any figure deviating from the same is the alpha.
Suppose, an ELSS Fund’s CAPM was shown as 5%; later, its actual returns turned out to be 8%. This difference is indicative of the fact that the asset manager was able to produce 3% more profits than was anticipated.
When calculating beta in Mutual Funds, there are two key components – covariance and variance. Covariance shows how two separate stocks react to each other in different market conditions. A positive covariance would suggest that two stocks move in compliance with each other, and a negative covariance indicates that two stocks move in opposite directions.
Variance, on the other hand, is directly relevant to a fund’s price deviation from its average or mean and represents the price volatility of that fund across a period.
The beta Mutual Funds formula is Covariance/Variance of Market’s Returns.
Apart from alpha and beta, there are several different ratios that quantify a fund’s performance. These ratios help substantiate the history of an asset and are further used to compare with other assets of the same kind. These ratios are –
It is used to measure the variation of a set of data from the mean or average. In the case of Mutual Funds, the standard deviation indicates the digression of Mutual Fund returns in different phases of the market from the average or mean as calculated prior. Financial advisors and investors use this data to gauge a specific fund’s volatility.
It is used by investors to measure the return provided by a fund in comparison to the risk it carries. The process of calculating the Sharpe ratio includes deducting the risk-free rate from the mean figure. Simply, it helps analyse the profits earned from varying degrees of risk. In other words, it represents the risk-adjusted return of an investment.
Price-earnings ratio or PER represents how much a single unit of a fund can earn and what price is to be paid for that unit. It is the ratio between the current price of a single unit of a fund and the earnings per share of it.
It indicates the percentage of fund returns that conform to the movements in the existing benchmark index. In principle, this method is the closest to alpha and beta ratios. R-square ratio figures lie somewhere between 0 and 1. The value 0 suggests that there is no percentage of funds in a portfolio reacts to movement in its respective benchmark index; whereas the value 1 represents that change in the benchmark index mirrors the movements in fund returns.
Alpha and beta, along with these ratios draw a complete picture of a fund or portfolio’s history and forecasts solid grounds to make future predictions. Investors significantly benefit from these data as it lets them decide which best complements their investment objectives.
If an individual prefers higher returns over low risks, he/she can invest in funds with a beta in Mutual Funds lower than 1. Similarly, an asset can also be selected based on an asset manager’s alpha in Mutual Funds.