An effective metric in assessing the performance of mutual funds, let's understand what alpha is and how you can find it
15-Sep-2023 •Ashish Menon
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.
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."
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).
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.
|Category of funds||% of funds with positive alpha||Average alpha of top five funds (%)|
|Large & Mid-cap||85||4.3|
|Note: As of August 31, 2023, based on performance over the last five years.|
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