Understanding Alpha in Mutual Funds

Did you just hear the anchor on CNBC or that fund manager talking about Alpha? You must surely be confused about what this concept is all about? Here is a quick rundown on what alpha is all about?

Let us start with a very simple question as to why does a person invest money in mutual funds. The expectation of the investor is that the fund manager will use the fund management skills, team of traders and analysts to zero in on quality stocks at attractive prices. Let us just understand a little differently.

If in the last 1 year, Nifty generates 18% returns during the year and the fund manager also gave 18%, you are going to start thinking what is the fund manager doing. Obviously, 1 year is too short a period but let us just understand hypothetically. You would see no point in investing in that equity fund. You would be better off putting money in an index fund or index ETF and just forget about it.

Now to attract you as an investor, the fund manager must be able to generate excess returns. That means he will be able to generate more returns that you expect. That excess returns is called Alpha. In other words, Alpha is the excess return that the fund manager generates compared to what is expected of the fund manager. That is easier said than done because we don’t know that the investors expects. That can be understood by going a little into the concept of Beta.

That is because it is not possible to understand Alpha unless you understand Beta. Let us look at a slightly more practical perspective. Beta is a measure of the systematic risk of a stock or a portfolio. What do we understand by systematic risk? It refers to risks that uniformly impact all stocks in the market and there is not much you can do about it. This systematic risk cannot be diversified by buying other stocks. If you are holding Tata Motors and you expect the chip shortage to hit auto production, you can shift out of Tata Motors. However, if the US raises interest rates or if the Evergrande crisis blows up in China, then all the companies are going to be hit badly. That is systematic risk and cannot be diversified away. This systematic risk is measured by Beta.

Why did we talk so much about Beta in our discussion of Alpha? Now, alpha is the excess returns that the fund earns over and above what the fund is expected to earn. To calculate what the fund is expected to earn you use the Capital Asset Pricing Model or CAPM. The Beta is at the core of the CAPM.

                                    Expected Return (ER) = Rf + Beta x (Rm – Rf)

ER = The return you expect on a stock or portfolio

Rf = Risk free rate of return that you can earn on government bonds

Rm – Market return on the Nifty

Beta – systematic risk (less than 1 is defensive and more than 1 is aggressive)

                                    Alpha = R – {Rf + Beta x (Rm – Rf)}

In short, if you have a higher beta then the expected returns on your portfolio will be higher and if you have a lower beta then the expected returns on your portfolio will be lower. That will impact your alpha too.