Know Alpha, Beta to understand risk of your mutual fund

Many new investors are entering mutual funds through SIPs and lump sum investments. Instead of merely looking at the returns in isolation, they need to understand the excess returns their fund generates when compared to the benchmark

What Are Alpha And Beta In A Mutual Fund?
Alpha and Beta are key measures of risk in a mutual fund scheme. Both are calculated using the scheme’s return, benchmark return and risk-free return. Alpha measures the risk-adjusted returns of a mutual fund, while beta indicates a fund’s sensitivity to market movements

How Are They Relevant To Investors?
Whenever one puts money in an actively managed equity scheme, the intention is to bene?t from fund manager’s skills in identifying high-quality stocks and earn more than the benchmark index. For example, if the Nifty 50 gives a 15% annualised return over ?ve years and the large-cap scheme returns the same as well, an investor would be better off with an index fund. Hence, to attract investors, the fund manager must be able to generate greater returns than the benchmark. This is called Alpha. Beta, on the other hand, helps you understand how a fund reacts to market volatility. It is an indicator of the fund’s stability and sensitivity to market fluctuations

How Are Alpha And Beta Calculated?

They are calculated using the Capital Asset Pricing Model (CAPM) formula. For Beta, the formula is: Beta = [(Mutual fund return – risk-free rate )] ÷ [(Benchmark return – risk-free rate )], whereas for Alpha, the formula is: Alpha = [(MF return – risk-free return)] – [(Benchmark return – risk free return) × Beta]

How Should Investors Use These Measures?
An Alpha above zero indicates that the mutual fund earns more than the index, while an alpha less than zero suggests that the fund underperforms an index. The beta factor gives insight into the risks of investing in a fund. If the fund’s beta is high, it shows that the risks are high. Consequently, investors with a low risk tolerance can choose funds with a low beta and vice versa Financial planners believe alpha and beta assist investors in fully understanding anticipated returns and risks associated with investing in a fund, permitting them to make informed investment decisions. They can be used in conjunction with other factors like fund house pedigree, the ability of the fund manager to navigate cycles, past performance, and other factors while choosing a mutual fund scheme.