Picking the right mutual fund needs research. You need to look into several factors like risk profile, duration, asset class, investment objectives of the fund, rating of the fund etc., before picking the fund. Apart from these, an investor also looks at how the fund performs.
Asset management companies have professional managers to manage your money. They know when to buy or sell a particular stock on your behalf. You can evaluate their performance too. There are several measures to assess the fund’s performance. Among them are alpha and beta. These metrics help you understand the fund performance. According to the rules laid out by the Securities and Exchange Board of India (SEBI), each fund house needs to choose a benchmark index, such as the Nifty50, the BSE SENSEX, the NIFTY 500 and S&P BSE200. The asset management company can determine one of these as the benchmark index, and the performance and returns of that mutual fund scheme are compared against this index.
What is beta?
Beta is how the fund responds to any changes in the benchmark index. It is the variation in the fund value when markets are volatile. Beta is a measure of how responsive the fund is to the volatility of the benchmark index. Knowing the stability and volatility of the fund will help the investor make easy investment decisions. Markets are said to have a beta of 1. If the beta of a particular fund is greater than 1, it is more volatile than the market. If the stock has a beta of 1.5, it is 50% more volatile than the market. But if a stock has a beta of 0.7, it is 30% less volatile than the market. It is important to note that beta is a number based on past performance and cannot predict how the fund will perform in the near future.
Calculation of beta
There is a mathematical formula to calculate beta. It is expressed as covariance divided by variance.
Beta = Covariance/ Variance
Covariance = The changes in the stock’s returns in relation to the change in the market’s returns
Variance = How far the market reacts relative to its mean over a period of time
Let us take an example of a company, XYZ Ltd. Let us assume by calculation that the covariance is 0.050 and the variance is 0.022. Using the formula,
Beta of XYZ company = 0.050/0.022
Beta of XYZ company = 2.27
This shows that ABC company is 127% more volatile than the National Stock Exchange whose beta value is 1.
What is alpha?
Alpha compares the returns of a fund to the returns of the benchmark index. It is a single number that lets an investor know the percentage above or below a benchmark index that a fund price has achieved. If the number is 10, the fund did 10% better than the benchmark index and if the number is -10, the fund did 10% worse than the index. This number will help an investor realize how a fund has performed compared to the market as a whole. This number will help the investor track the fund’s performance over a period. Like beta, this number will not be able to tell the investor how the fund will perform in the immediate future. This also measures the risk involved in the fund. An alpha of -20 means that the fund is far too risky compared to the returns it provides. An alpha of 0 means the risk is proportionate to the returns and an alpha of more than zero means that investment has outperformed. It measures the capability of the asset manager in guiding the fund to make profits in comparison to the benchmark index. An alpha of 0 shows that the asset manager’s performance is equal to the benchmark index.
Calculation of Alpha
There is a formula to calculate alpha. It is given by:
Alpha= r- Rf-beta (Rm-Rf)
r = the fund’s return
Rf= the risk-free rate of return
Beta = the fund’s price volatility when compared to the overall market
Rm = the market return.
The risk-free rate of return is the rate of return of an asset that has no risk
Let us assume the actual return of the fund is 20. The risk-free rate is 5%. Beta is 1.1 and the benchmark return is 10%.
Then alpha is = (0.20-0.05) – 1.1(0.10-0.05)
Alpha= (0.15) -0.055
Alpha =0.095 or 9.5%
This shows that the fund outperformed the index by 9.5%
Conclusion
Alpha and beta help an investor calculate, analyse and predict the risk and returns in a mutual fund. But an investor needs to be careful since there are different types of funds with different classes of assets. As each fund has a diverse nature, these results can be misleading. Investors also need to be careful while choosing the benchmark index. Each fund should be compared to the index that will provide a more accurate comparison.