What is Alpha in Mutual Funds

In many investment-related conversations, we hear the word "Alpha". We hear that fund managers manage funds actively to generate alpha. So, let's understand the meaning of alpha in a much simpler way.

Alpha is a term used to describe how well a particular investment performs compared to the expected returns. It shows excess returns generated by the fund over its expectations. But for a mutual fund, how do we set expectations?

For that, we use the Capital asset pricing model (CAPM). It is a simple-to-use model, but it has certain limitations as well. We are not going to go deep into its technicalities right now. Let's understand this model with an example.

Expected Returns: The Capital Asset Pricing Model

To understand this concept, you must understand what risk-free returns are. 

Risk-free returns are the returns generated without taking any risks. For example, the return on government bonds can be considered a risk-free rate as they are considered the safest investment.

Now, according to this model, the expected return of a portfolio is defined as:

Expected Return = Rf + beta (Rm-Rf)

Where:

Rf = Risk-free rate of return

Beta = Systematic risk of a portfolio

Rm = Market return (benchmark return)

Let's say a mutual fund portfolio has a beta value of 0.8. The risk-free rate is 7%, and the benchmark has generated a 10% return in the year. So as per the formula,

Expected return = 0.07 + 0.8*(0.1-0.07)

= 0.094

= 9.4%

This return is expected from the fund. Risk and return go hand in hand. Higher the risk, the higher the return. As the fund manager invests in riskier assets like stocks and bonds, the expected return is also higher than our risk-free rate of 7%.

How to Calculate the Alpha of a Mutual Fund?

Now let's say that the fund manager of the above-mentioned fund has generated a 12% return in the same year. Alpha is nothing but the difference between actual and expected returns.

Alpha = R – Expected return

Alpha = R – [Rf + beta (Rm-Rf)]

Alpha = R – Rf – beta (Rm-Rf)

Where:

R represents the portfolio return.

So from our above calculation, we can say that 

Alpha = 0.12 - 0.094 = 0.026 = 2.6%

We can say that the fund manager has generated positive alpha. A positive alpha indicates that the fund manager is performing above expectations. If the alpha value is negative, then we can say that the fund manager is not managing the money efficiently and underperforming the benchmark.

You can look at the alpha value of any mutual fund on Sharpely in the performance section of the fund.

FAQs

How is the alpha of a mutual fund different from the beta?

The alpha of a mutual fund shows the fund's outperformance compared to the expectations. On the other hand, a fund's beta is an indicator of relative volatility compared to the benchmark index. In a nutshell, alpha is used to analyze performance, and beta is used to analyze volatility.

What is a good alpha value for a mutual fund?

There is no exact number for a good alpha value. Rather than looking at the absolute alpha value, you should look at the trend of yearly alpha over time. If the fund manager consistently generates positive alpha, then that fund can be considered for further analysis.