Understanding Alpha and Beta in Mutual Funds
Alpha
Alpha is the returns generated by a fund in excess of expected returns. Expected returns would be calculated using CAPM. A high beta fund would be expected to generate higher returns as opposed to a low beta fund.
CAPM = Risk free rate + the beta of the investment* (the expected return on the market - the risk free rate)
The baseline for alpha in Mutual Funds is 0.
Alpha > 0 means the fund has generated higher returns than the benchmark index.
Alpha < 0 means the fund has generated lower returns than the benchmark index.
For instance a fund with 1.5 beta would be expected to deliver 16.5% if the benchmark returns were 12% with a 3% risk free rate. Whereas a fund with just 0.8 beta would be expected to deliver only 10.2%.
Hence, if two funds delivered 13% then only the low beta fund has generated positive alpha.
Beta
Beta ratio in Mutual Funds offers investors the data on the degree of the volatility a Mutual Fund displays in response to market fluctuations.
Suppose, the beta ratio of a specific Mutual Fund is 0.7 or 70%; it means the fund is 0.3 or30% less volatile than the benchmark index.
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.
In conclusion, understanding Alpha and Beta in Mutual Funds is crucial for investors.