Alpha measures a mutual fund’s performance compared to its benchmark index. A positive alpha indicates that the fund has outperformed its benchmark, whereas a negative alpha indicates underperformance.
Contents:
- What Is Alpha In Mutual Fund?
- How To Calculate Alpha In Mutual Funds?
- Beta In Mutual Fund
- What Is Alpha In Mutual Fund – Quick Summary
- Alpha In Mutual Fund – FAQs
What Is Alpha In Mutual Fund?
Alpha represents the returns a fund generates more than its benchmark index. Simply put, alpha is the difference between the fund’s actual returns and the expected returns based on its risk level. A high alpha is generally considered a sign of good fund management.
Consider a mutual fund, “ABC Equity Fund,” that has generated a return of 15% over the past year. The benchmark index, NSE Nifty 50, has returned 10% in the same period. If the fund’s beta is 1, the expected return is also 10%. The alpha here would be 15% (actual return) – 10% (expected return) = 5%, indicating that the fund has outperformed its benchmark.
How To Calculate Alpha In Mutual Funds?
Steps to Calculate Alpha:
- Obtain the actual return of the mutual fund over a specific period.
- Get the return of the benchmark index for the same period.
- Find the fund’s beta, which measures its volatility compared to the market.
- Calculate the expected return using the formula: (Benchmark Return * Fund’s Beta).
- Subtract the expected return from the actual return to get the Alpha.
Let us take an example to understand this in a better way:
Actual Return of the Mutual Fund: You have invested in the “ABC Equity Fund,” and its actual return over the past year is 15%.
Benchmark Index Return: The benchmark for this fund is the NSE Nifty 50, which has returned 10% over the same period.
Fund’s Beta: The beta value for “ABC Equity Fund” is 1.1. This means the fund is slightly more volatile than the market.
Calculate Expected Return: Using the formula (Benchmark Return * Fund’s Beta), the expected return would be 10% * 1.1 = 11%.
Calculate Alpha: To find the Alpha, you subtract the expected return from the actual return: 15% – 11% = 4%.
In this example, the Alpha for “ABC Equity Fund” is 4%. This means the fund has performed 4% better than expected based on its benchmark and volatility. An Alpha of 4% is generally considered good and indicates that the fund manager has successfully added value.
Beta In Mutual Fund
Beta is another crucial metric in mutual fund analysis. It measures a fund’s sensitivity to market movements. A beta of 1 indicates that the fund is expected to align with the market. A beta greater than 1 suggests higher volatility, while a beta less than 1 indicates lower volatility.
The term “beta” in mutual funds is like a yardstick that tells us how much a fund’s value will change when the stock market changes. Suppose a fund named “XYZ Equity Fund” with a beta of 1.2 it’s a bit more sensitive to market changes compared to the average stock market index, which has a beta of 1.
So, here’s what it means in everyday terms:
- If the stock market goes up by 10%, our fund is expected to go up by 12% because it’s a bit more sensitive (that’s the 1.2 beta value at work).
- Similarly, if the stock market drops by 10%, our fund will likely go down by 12%.
Understanding this beta value helps you know that “XYZ Equity Fund” will generally move a bit more than the market, whether the market is going up or down. This information can help you decide if this fund fits your investment goals and how much risk you’re comfortable taking.
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What Is Alpha In Mutual Fund – Quick Summary
- Alpha is a measure that tells you how well a mutual fund has performed compared to its benchmark. A positive Alpha indicates the fund has outperformed its benchmark.
- Alpha is calculated using the actual return of the fund, the return of the benchmark index, and the fund’s beta. Alpha = Actual Return – (Benchmark Return * Fund’s Beta).
- Beta measures a fund’s sensitivity to market movements. A beta of 1 means the fund moves in line with the market, while a beta greater than 1 indicates higher volatility and a beta less than 1 indicates lower volatility.
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Alpha In Mutual Fund – FAQs
Alpha in a mutual fund is a metric that shows how much better or worse the fund has performed compared to its benchmark index.
An alpha of 1 or above is generally considered good, indicating that the fund has outperformed its benchmark.
The higher the alpha, the better. An alpha of 4 or 5 is considered excellent, as it shows significant outperformance compared to the benchmark.
The alpha rating of a mutual fund is a numerical value that represents its performance relative to its benchmark. A positive alpha rating indicates outperformance, while a negative alpha indicates underperformance.
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