How to Pick Best Mutual Fund Schemes with Alpha and Beta Ratios?
If you are selecting a specific stock for long term investments, you would do fundamental and technical analysis. However, if you are investing in mutual funds, you would generally go with past performance and how it was able to perform in various market cycles. There are several ratios which mutual fund experts consider in recommending best mutual fund schemes for long term investment. Some of the ratios are Alpha and Beta in Mutual Funds that can help you to pick-up right mutual fund scheme to invest. What are Alpha and Beta in Mutual Funds? How you can pick-up best mutual fund schemes with Alpha and Beta? How you can assess about the volatility of your mutual fund schemes with these ratios? How you can pick-up a high risk and high return mutual funds with these ratios?
How do you pick-up mutual fund schemes?
Generally, we pick-up mutual fund schemes based on any of the following criteria
1) Mutual Fund schemes that outperformed in the short term, medium term and long term.
2) Mutual Fund Schemes that have good credit rating from Value Research, Crisil and Morning Star.
3) Mutual Fund schemes recommended by MF experts.
4) Mutual Fund schemes that are expected to outperform based on decision making by Government (e.g. Thematic sector funds like Infra funds or banking funds).
5) Mutual Funds with Sharpe Ratio etc.,
However, none of these criteria would help to know mutual fund investor, how such schemes would perform in volatile markets or how well these would perform in bull run or bear run. Here come Alpha and Beta ratios. Just look at the various parameters indicated below where one would consider while selecting a good mutual fund scheme including Alpha and Beta.
What is Alpha in Mutual Funds?
In simple terms, Alpha is used as a measure of performance against a benchmark or a market index over a specified return. It indicates whether a portfolio manager has managed to beat the market return over the expected. Alpha can be seen as a measure of the fund manager’s performance. This indicates that what the fund has performed over (or under) its expectations.
It is commonly used to rank active mutual funds as well as other types of investments. Positive alpha represents the contribution a fund manager has made for the fund’s return. It implies that the fund has performed better than expected. So, higher the alpha, better the returns. It is often represented as a single number
Alpha in Mutual Funds explained with an example
Alpha is often considered to represent the value that a portfolio manager adds or subtracts from a fund’s portfolio return. An alpha of 1.0 means that the fund has outperformed its benchmark index by 1%. In the same way, an alpha of -1.0 would indicate an underperformance of 1%. For investors, the higher the alpha, the better it is.
What is Beta in Mutual Funds?
A Beta is a statistical tool which tells us about the relative volatility of a mutual fund as compared to its particular market index and thereby denotes the risk profile of the mutual fund.
Beta measures the sensitivity of the funds to its index. It shows the relation between the fund’s returns and that of its index. The Beta value for the corresponding market for the mutual fund is taken as 1. Any value more than 1 denotes more volatile and a value less than 1 denotes less volatile. Beta is basically a measure of volatility. A 1.2 beta fund is more volatile than a fund with beta 1. It warns the investors to invest in funds with high Beta.
Beta in mutual funds explained with an example
A beta of 1.0 indicates that the price of an investment will move in lockstep with the market. A beta of less than 1 indicates that the investment is less volatile than the market. Correspondingly, a beta of more than 1.0 indicates that the price of an investment will be more volatile than the market. For instance, if a fund portfolio’s beta is 1.2, theoretically it is more 20% more volatile than the market.
Talking about a specified mutual fund, take HDFC small cap. Its Beta value is 0.8. This indicates that if Nifty Midcap 100 moves up 10% in one month, this fund moves up by 8%. On the other hand, if Nifty losses by 10%, this fund loss by 8%.
Can we choose a good mutual fund scheme with Alpha and Beta?
Alpha and Beta are extensively used by the investment managers to calculate, compare and analyze returns. While selecting the mutual funds, the investors need to use mutual fund alpha and beta as per the risk profile. Low-risk appetite investors should look for a mutual fund with lower Beta and investors willing to take more risk in search of higher returns should look for high beta investments. While everyone wants to opt for mutual funds with higher alpha and lower beta but they need to understand that it is difficult for a mutual fund manager to generate higher alphas without corresponding higher Beta.
A knowledgeable and goal-oriented investor would both the tools efficiently to pinpoint best mutual funds. Alpha tells you whether a particular fund has produced returns justifying the risks it is taking by comparing its actual return to the one predicted by the beta. For example- a fund can be expected to earn a return of 15% in a given year based on its beta. However, it fetches you the return of 18%. Then, the alpha of the fund is simply 18-15=3.
Samples about Low Beta and High Alpha Mutual Funds in India in 2019
1) HDFC Small Cap Fund has a beta of 0.7 and Alpha of 8.0.
This means, if NIFTY Smallcap 100 (fund benchmark) increases by 10%, this fund would provide 18% returns (8% higher i.e. with 8 Alpha).
If NIFTY SmallCap 100 falls by 10%, it would fall only by 7% (0.7 beta).
2) Mirae Asset Large cap Fund Direct plan has beta of 0.93 and Alpha of 3.31.
If NIFTY 100 (Benchmark for this fund) increased by 10%, this fund would provide 13.31% (3.31 Alpha).
If this benchmark crashes by 10%, this mutual fund would fall by 9.3% (0.93 Beta).
If you want to take high risk and looking for high returns from mutual funds, you can invest in high Alpha and Low Beta Mutual Fund schemes that can fetch you good returns. We would be filtering such funds in coming week’s articles.
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How to pick Best Mutual Fund Schemes with Alpha and Beta Ratios