Understanding alpha in mutual funds

When it comes to assessing the performance of mutual funds , simply comparing their returns can be misleading. Opting for a fund with the highest returns doesn't necessarily mean it's the best choice. This approach overlooks the vital element of risk. To make a more informed judgement, experts turn to risk-adjusted returns.

For that, "alpha" stands as one of the most effective yardsticks.

What is alpha?

In the Greek alphabet, "alpha" is the first letter. It symbolises being at the forefront or dominating a field. Applied to mutual funds, funds with the highest alpha are considered to provide investors with the most value, especially in the realm of actively managed funds. But what exactly does "alpha" signify in the context of mutual funds?

Imagine it's your anniversary, and you're eagerly awaiting a special evening with your spouse. You expect a nice dinner, but to your amazement, he sweeps you off your feet with a lavish dinner and a sparkling jewellery set. That is what we call "positive alpha" in the world of investing. It's the fund that goes above and beyond expectations, just like your thoughtful partner. Now if he completely forgets about the anniversary and doesn't do any special thing, that is what we call a "negative alpha".

Alpha measures the excess returns generated by a fund over its expected returns, accounting for the costs of fund management. Expected returns, in turn, comprise risk-free returns plus market returns adjusted for the fund's level of risk, as quantified by "beta."

Understanding alpha with an example

Suppose a fund has delivered 20 per cent returns over the last three years while its benchmark managed only 15 per cent during the same period. Assuming the fund's beta is 0.85, and the risk-free rate during that period was 3 per cent:

The expected return would be 13.2 per cent (0.03 + 0.85 x (0.15 - 0.03)).
The alpha, in this case, would be 6.8 per cent (20 - 13.2).

The quest for alpha

Now that we understand what alpha is, let's hunt for it. We'll delve into the performance of actively managed pure equity funds over the past five years to see who's leading the pack.

Who holds the alpha crown?

What we found

• Small-cap funds (almost all) consistently generate the most alpha.
  
• Large-cap funds face challenges in generating alpha. Even the top performers in this category produce little alpha when compared to the top funds in other categories.
  
• Flexi-cap and ELSS funds exhibit similarities, except for the alpha generated by the top five funds (as can be seen in the table). This is because of the distinct nature of focused funds and flexi-cap funds investing in international stocks.

Here's how you can find alpha

If you're curious to discover the alpha generated by your funds, simply navigate to the "risk" tab on your fund's page or use the fund screener on Value Research Online to compare the alpha generated by your fund in comparison to other funds. These alpha values are based on performance of the funds over the last three years.

Suggested read: How to statistically analyse funds