What are Alpha and Beta in Mutual Funds?

Have you ever wondered if your mutual fund’s returns are higher than the market's? In today's fast-paced financial world, knowing your fund is growing is not enough; you must also understand how well it performs in comparison to the market benchmark. That is where Alpha and Beta come in. Alpha represents an asset manager's performance in guiding a fund to profitability relative to the benchmark index. On the other hand,  Beta in mutual funds measures a fund's volatility in comparison to the overall market.

In this article, let’s look at what is alpha and beta in mutual fund mean, why they matter, and how investors can use them to make smart investment decisions.

What is Alpha in Mutual Fund?

Alpha in mutual funds refers to how well a fund manager has performed in managing a fund compared to a benchmark index. It shows the value added by the manager’s decisions, indicating whether their strategy helped the fund do better or worse than the market.

Interpretation of Alpha in Mutual Fund:

• When an alpha is positive, it indicates fund outperformance compared to its benchmark, which is typically greater than zero after accounting for risk. For example, an alpha of 2% shows that the fund has outperformed the benchmark by 2%. 

• An alpha is negative when the fund is underperforming the benchmark due to poor investment decisions. For example, an alpha of -5 indicates that the fund underperformed the benchmark by 5%.

• An alpha is zero when the fund’s performance is in line with the benchmark. It means the fund returns have not delivered outperformance or underperformance.

How is Alpha Calculated?

To get the Alpha ratio in mutual funds, we might ask ourselves, "Why not just subtract the mutual fund returns from the benchmark returns?" In that instance, we will disregard both the market conditions and the fund's risk. So to overcome those, we can use the Capital Asset Pricing Model (CAPM). It is commonly used to calculate alpha, which calculates an investment's expected return based on its risk profile. It involves particular formulas and steps:

Formula:

Alpha = Fund Returns - [Risk-Free Rate + (Market Returns - Risk-Free Returns) * Beta]

Where, 

• Fund Returns: This will help in determining the actual return that is generated from the funds.

• Risk-Free Rate: Calculate the return rate for risk-free securities (government bonds).

• Market return: The returns earned by investments.

• Beta: It is a measure of a fund's volatility relative to its benchmark.

• Benchmark Return: The average annual return of the benchmark index

Let us understand this by an example

Assume that over a year, a mutual fund generated a 15% return, while the market index generated a 12% return. The risk-free rate is 7%, and the beta of 1.02.

Using the CAPM Alpha method, we calculate the risk-adjusted return as

Alpha = Fund Returns - [Risk-Free Rate + (Market Returns - Risk-Free Returns) * Beta]

Alpha = 15% - [7% + (12% - 7%) x 1.02] 

Alpha = 15% - [7% + 5% x 1.02] 

Alpha = 15% - [7% + 5.1%] 

Alpha = 15% - 12.1% = 2.9%

Accordingly, the fund’s return exceeded its market risk-based expectation by 2.9%, which is only a measure of return over the index.

What is Beta in Mutual Fund?

Beta is a tool that is used to understand how sensitive a mutual fund is relative to its benchmark. It is a statistical measure of volatility that includes systematic and unsystematic risk measured through standard deviation.

Interpretation of Beta in Mutual Fund

• Beta greater than 1 indicates the fund’s volatility is higher than the benchmark. It means the fund rises higher than the benchmark during its good economic condition. Funds under this category are riskier but also offer high returns in a bullish market. 

• Beta less than 1 indicates when a fund is less volatile than the benchmark. If a fund has a beta of 0.5, it means the fund is 50% as volatile as the benchmark. Let’s say if the benchmark falls by 10%, and the fund drops by 5%, thus offering more stability in the volatile market.

• Beta equal to 1 indicates that the fund is highly correlated with the market. For example, if the benchmark rises by 5%, so will the fund. 

• Beta is negative when the fund is inversely correlated with the market. The prime example of this is gold ETFs, as their value rises when the stock market declines.

How is Beta Calculated?

Here’s how the Beta ratio in mutual funds is calculated for a mutual fund:

Formula:

Beta = Covariance (mutual fund returns, Market returns) / Variance (market returns)

• Covariance - It determines the relationship between the returns of a mutual fund and the market

• Variance -  It determines how a mutual fund’s return deviates from its average.

Let us understand this by an example:

Assume an investor wants to assess how volatile the ABC growth fund is by calculating its beta against the Nifty 50. The ABC Growth Fund and the Nifty 50 have a covariance of 18.75, and the variance of the Nifty 50 is 48.06.

Beta = 18.75 / 48.06

Beta = 0.39

The ABC Growth Fund tends to move 39% as much as the Nifty 50, or the fund is less volatile than the Nifty 50 with a beta of 0.39.

Difference between Alpha and Beta

After understanding the meaning, formulas, and examples, we will take a look at the differences between Alpha and Beta, which are as follows:

Why are Alpha and Beta Important for Mutual Fund Investors?

Alpha is a critical metric when investing in mutual funds to understand risk-adjusted returns compared to a benchmark. Alpha has several advantages for the investors, some of which are:

• It shows how a fund manager improves a portfolio beyond what the market would provide on its own.

• When the economy is doing well, more businesses succeed, and the market (index) rises naturally. 

• During these periods, small and mid-cap companies typically outperform larger, well-established (blue-chip) companies. 

• Investing in high-growth funds, aggressive fund managers can outperform the market’s return by producing a positive alpha.

• Positive alpha indicates that the fund management made wise decisions and generated additional profit in addition to depending on market growth as a whole.

Beta is one of the tools that can be considered while investing in a fund. Here is why the beta is an important measure:  

• Beta is an important tool in mutual fund analysis because it measures a fund's volatility about its benchmark index, indicating how a fund may perform under different market conditions.

• By comparing a fund's beta to its past returns, investors can determine whether a high-beta fund provided higher returns or a low-beta fund provided adequate safety during market downturns, depending on their investment strategy.

• You can mitigate the risk by diversifying your investment among assets with lower beta values. For example, if you own stock mutual funds in different categories, adding assets such as debt funds or gold ETFs might help balance risk and preserve your portfolio.

• Beta is used to evaluate mutual fund performance, especially for investors worried about market volatility, by comparing beta values within the same category. This will help investors to decide whether an investor can decide if a fund matches their financial goal.

What is the Ideal Range for Alpha and Beta?

When selecting a mutual fund, whether it's an ELSS, large-cap, or other type, reviewing prior performance allows you to make more informed judgments.

The alpha ratio helps measure how well the fund manager performed in comparison to the market benchmark. For example, if the fund returns 10% while the market returns 8%, the 2% difference indicates that the fund manager generated additional value. Investors aim for funds with an alpha of 1.5 or greater, based on average past performance compared to relying on recent results.

Beta, on the other hand, measures how much the fund fluctuates in response to changing market conditions. A higher beta indicates that the fund is more volatile, while a lower beta indicates that it is relatively stable for investors. There is no ideal range for beta, as it is dependent on the investment. However, a beta less than 1 is better for risk-averse investors.

Conclusion

Understanding alpha and beta in mutual funds is essential for making sound investment decisions. These two metrics reveal more than just how much a fund is growing; they also explain how and why that growth occurs. Alpha assesses whether the fund manager is truly adding value beyond the market's natural movement, whereas Beta determines how sensitive the fund is to market ups and downs. Using both together allows investors to strike a risk-reward balance that is consistent with their financial goals and risk tolerance.

FAQs

Q. What is a good alpha ratio? 

An alpha greater than 0 is considered good for mutual funds. This indicates that the fund manager has outperformed the benchmark index in terms of returns as a result of wise investment choices.

Q. Is beta better or alpha?

Both contribute to the overall risk and return of an investment portfolio; both must be taken into consideration for any investment decisions.

Q. What is a good beta ratio for a mutual fund?

Beta is neither good nor bad. If you are considering that markets can be volatile, a beta that is close to 1 is generally good for investors.

Q. Is Alpha positive or negative?

Alpha can be positive or negative, indicating whether a portfolio is outperforming or underperforming its benchmark.

Q. How to calculate alpha?

Alpha is usually derived using the Capital Asset Pricing Model (CAPM), which calculates an investment's expected return based on its risk, using the formula: Alpha = Rp - [Rf + (Rm - Rf) × Beta].

Q. What is negative alpha in a mutual fund?

An investor’s alpha is negative if their investment portfolio is underperforming a particular benchmark due to poor investment decisions.