What is alpha and beta in mutual funds?

The financial market involves a lot of complexities to quantify the risk, performance, and various other metrics of various investment instruments. To simplify these complexities andto help make the right investment decision, there are quite a few components that determine the risk and reward aspects of your investment.

The mutual funds landscape has its own set of financial ratios to help investors in making the right choice that might benefit them. Among these financial ratios are alpha and beta in mutual funds. Alpha and beta are both standard ratios that are used to analyse the portfolio’s performance along with some other standard ratios such as Sharpe Ratio, R-Squared, and Standard Deviation.

What is alpha?

Alpha measures the performance of an asset manager to guide a fund into yielding profits in comparison to its benchmark index. A benchmark index is an index against which a fund’s performance is measured.

The baseline for alpha is zero. The higher the alpha of a fund, the better is its performance in comparison to its benchmark index. If the number is negative, it shows the asset manager’s and the fund’s performance is not up to the mark. Any positive number denotes that the asset manager and the fund have successfully outpaced the benchmark index.

Example:

-If the alpha figure of a fund is 5, it denotes that the fund has outperformed its benchmark index by 5%.

-If the alpha figure of a fund is -3, the fund is underperforming its benchmark index by 3%.

 – If the alpha is 0, the fund returns have matched that of its benchmark index.

What is beta?

It is also referred to as Beta Coefficient and is used to quantify a fund’s volatility in comparison to a benchmark index.

The baseline for beta is 1. Beta value that is greater than 1 suggests that the fund is more volatile than the benchmark index. Beta value of less than 1 signifies that the fund is less volatile than its benchmark index.

Example:

-If the beta value of a fund is 1.27, it means that the fund is 27% more volatile than its benchmark index.

-If the beta value of a fund is 0.46, it shows that the fund is 46% less volatile than its benchmark index.

-If the beta value is exactly 1, it denotes that the fund is just as volatile as the benchmark index.

Why are financial ratios such as alpha and beta important?

There are more than 2000 mutual fund schemes available in the Indian market, making it essential for investors to choose the right fund that would help them in reaching their financial goals. For this, these ratios are necessary to quantify the fund’s growth potential, risk, performance, etc.

In a nutshell, alpha for the past few yearsindicates whether a fund is worth pursuing depending on the asset manager’s capability to generate profits for their fund, while beta helps investors to decide whether it’s worth the risk depending on the fund’s response to market volatility.