How to pick a Good Mutual Fund Scheme using Jensen’s Alpha ratio?

While investing in mutual returns, many people invest taking into account only historical returns. There are several other general factors like ranking, expense ratio, long term performance, consistent performance, etc., However one of the key element is Risk factor. Investors need to analyze carefully about the risk factors involved in the mutual funds. There are a number of tools and ratios that help the investors in investigating about the factors like risk, returns etc. associated with the mutual funds. One of the key method is assessing risk is Jensen’s Alpha Ratio. What is Jensen’s Alpha Ratio in Mutual Funds? How to pick-up a good mutual fund scheme by considering Jensen’s Alpha Ratio?

Also Read: Best Performing Mutual funds in 2018

What are various technical ratios used in picking up a good mutual fund scheme?

There are five technical risk ratios that are often used to rank the performance of mutual fund portfolio – Jensen’s Alpha, Beta, Standard Deviation, R-squared, and the Sharpe Ratio.

What is Jensen’s Alpha ratio?

Jensen’s Alpha ratio is a statistical measurement that shows the return given by a mutual fund or a mutual fund portfolio after adjusting the risk relative to the expected market return predicted by models like the Capital Assert Pricing Model (CAPM). The CAPM formula calculates the rate of return of a certain security or portfolio under certain market conditions. And if the actual return exceeds it, the difference is called as alpha. The higher the alpha, the better is the return of security or portfolio above the predicted level.

Jensen’s measure is a measurable way to determine whether the portfolio manager has contributed something to the value of the portfolio because alpha is attributable to the skill of the portfolio manager rather than the general market conditions.

Jensen’s Alpha Ratio measures the excess return of the fund over the benchmark.

Jensen Alpha Ratio was first used by Michael Jensen in the year 1968 for the purpose of evaluation of mutual fund.

What is the formula of Jensen’s Alpha ratio?

The formula of calculating Jensen’s Alpha ratio is-

Alpha = (fund return – risk free return)- (funds beta) *(benchmark return- risk free return)

Jensen’s Alpha Ratio explained with an example

Fund returns     10%

Risk free return 8%

Benchmark return 5%

Beta of Fund        0.8

By computing the above formula we will get alpha as 4.4 for this fund.

The positive alpha indicates that the mutual funds have outperformed its benchmark index. In the same way, a negative alpha means that the fund has underperformed from its benchmark index.

How to pick-up a Good Mutual Fund Scheme using Jensen’s Alpha ratio?

If the investor is testing his mutual funds on the Jensen’s Alpha Ratio, he must go with the fund that has high Jensen’s Alpha ratio.

Significance and negative factors in Jensen’s Alpha ratio

Jensen’s alpha is easy to calculate and it rewards the stock selection ability of the fund manager. Jensen’s alpha is important to investors as they need to take care about the quantum of risk involved in achieving that return and not only the total return of the security. For example, if two securities yield identical returns, but one involved lower risk than rationally, the one with lower risk would be preferred.

The biggest negative factor of Jensen’s Alpha is it requires an estimate of beta, which can differ a lot depending upon the source, which in turn can lead to a mis-measurement of risk adjusted return. In some cases, the negative alpha can result from the expenses that are present in the fund figures, but are not present in the figures of the comparison index.

Some good mutual fund schemes in India that have high alpha

Higher alpha gives us an indication of better performance against the benchmark. Below are presented some of the equity mutual fund schemes from large cap, mid cap and small cap. It can be a good parameter for analysis of funds and prove to be very handy for investors.

1) Under Equity Large Cap, Mirae Asset India Opportunities Fund – Direct Plan did well with an alpha of 5.95. SBI Blue Chip Fund – Direct Plan with an alpha value of 4.53 and Kotak Select Focus Fund – Direct Plan with 4.92 also performed well.

2) In Equity Mid Cap, Mirae Asset Emerging Blue-chip Fund – Direct Plan exhibits highest alpha with 12.49. L&T Midcap Fund – Direct Plan with 11.5 alpha value and L&T India Value Fund – Direct Plan with 9.5 alpha value also did well.

3) In Equity Small cap, SBI Small & Midcap Fund – Direct Plan outperformed with an alpha of 18.65. DSP BlackRock Micro Cap Fund – Direct Plan and HDFC Small Cap Fund – Direct plan with an alpha of 12.86 and 12.15 respectively did well in the small cap segment.

Should you consider Jensen’s Alpha ratio in choosing a good mutual fund scheme?

We are considering several parameters in choosing a good mutual fund scheme. Considering risk assessment as another factor in choosing a good fund would always be better. However, don’t go overboard and consider only this factor. This should be considering as one of the several parameters you might be considering while investing in a good mutual fund scheme.

Suresh

How to pick-up a Good Mutual Fund Scheme using Jensen’s Alpha ratio

1. Jatinder says:

Dear Suresh,

Hope you are doing well.

Currently I am having below MFs in SIP mode and I want to increase my SIP by 20k/month for period of 5 Years.

The below fund was stared around 1-2 years before.

UTI Transportation and Logistics Fund – 10K
ABSL Frontline Equity – 5k
ABSL Pure Value– 5k
ABSL Small Cap – 5k
Reliance Pharma – 5k
Reliance Small Cap– 5k
HDFC Small Cap– 5k
Tata Equity P/E Fund– 5k
Tata India Consumer – 15K

Regards,
Jatinder

1. Hello Jatinder, You are investing in good funds. However Travel/Logistics, Pharma industry and consumer theme are in down trend now. These may take some time to recover. You should be able to hold on to them for some time.

1. jatinder says:

Hi Suresh,
Should I continue my SIP in Travel/Logiscs, Pharma and Consumer Funds……looking for long term prospects (5 Years or more)

Also I want to increase my SIP by 20K….could you pls advise which funds will be better….time frame is above 5 years…

Many Thanks,
Jatinder

1. jatinder says:

Thanks Suresh!!!

2. Irfan says:

Dear Mr. Suresh,
sir, can you me your opinion regarding 2 funds i like to SIP

1. SBI Banking and Financial Services Fund – And How Much SIP Better for 5 yrs term
2. Any Good Balanced Fund – And How Much SIP Better for 5 yrs term.

Aditya Birla Sun Life Frontline Equity Fund (G) – SIP 1000
HDFC Mid-Cap Opportunities Fund (G) – SIP 1000
ICICI Prudential Value Discovery Fund (G) – SIP 2000
L&T India Value Fund (G) – SIP 1000
L&T Infrastructure Fund (G) – SIP 3000
Reliance Large Cap Fund – Retail Plan (G) – SIP 2000
Reliance Multi Cap Fund – Retail Plan (G) – SIP 4000
Reliance Small Cap Fund (G) – SIP 4000
SBI Blue Chip Fund (G) – SIP 2000

if you can please suggest & give Guidance that all my holding are good for average 5 yr term or should i change accordingly for better managing portfolio, i am bit confused

Regards

1. Irfan says:

Sir, I would much appreciate if you could Response to my query

Regards

3. Subramanian says:

Dear sir, I have an SIP of DSP small cap fund since sep 2016 onwards.pls advice can close the sip/ continue the sip.returns are less than invested amount.

1. Don’t worry about short term fluctuations. You can continue to invest in such funds for medium to long term of 5-10 years.

4. Kamal Garg says:

In what way, Jensen’s Alpha Formula is different from sortino ratio. Both capture the same thing – essentially excess of risk free return per unit of volatility or total risk.

5. gopal says:

Thanks you Sir.However you can share more funds in table format.