How to use alpha to evaluate mutual funds?

Investing in mutual funds continues to be a popular method among new and seasoned investors to grow their wealth over time. However, with so many mutual funds available, it can be challenging to determine which ones are suitable and worth investing in. One useful tool for evaluating mutual funds is Jensen’s Alpha.

Let’s take a closer look at what Alpha is, how to use Jensen’s Alpha to evaluate mutual funds, and how it can fit into your investment strategy.

• Table of contents

1. Understanding Alpha in mutual funds
2. Calculation of Alpha in mutual funds
3. Using alpha to evaluate mutual funds
4. Leveraging Alpha in investment strategy

Understanding Alpha in mutual funds

Alpha is a measure of a mutual fund's performance compared to a benchmark index. It shows how much better or worse a fund performed compared to what was expected, based on the market's overall performance. Simply put, Alpha tells you if the fund manager's investment decisions have added value beyond just following the market trends.

Calculation of Alpha in mutual funds

Alpha is calculated using the following formula:

Alpha = Fund Return − (Benchmark Return + β × (Market Return − Risk-Free Rate)

Returns from government bonds are typically considered as the risk-free rate, while the benchmark index return is considered as the market return. Beta measures the fund's volatility relative to the market.

For example, let’s say the Alpha of a mutual fund is +2. This means the fund has earned 2% more than its benchmark index. If the Alpha is -1, it means the fund has delivered returns that are 1% lower than the benchmark.

Positive Alpha: A positive Alpha indicates that the fund manager has outperformed the benchmark index, after adjusting for risk.

Negative Alpha: A negative Alpha suggests that the fund manager has underperformed the benchmark index.

Zero Alpha: A zero Alpha indicates that the fund manager has performed in line with the benchmark index.

Read Also: What is alpha and beta in mutual funds?

Using alpha to evaluate mutual funds

To understand how to use Jensen’s Alpha to evaluate mutual funds, let’s go through an example.

Let’s assume you are evaluating a mutual fund called XYZ Fund. Over the past year, XYZ Fund had a return of 12%. The benchmark index had a return of 10%, and the market return was 8%. The risk-free rate, which is the return on a very safe investment like government bonds, was 2%. The Beta of XYZ Fund is 1.1.

Using the Alpha formula:

Alpha = 12% − (10% + 1.1 × (8% − 2%))
Alpha = 12% − (10% + 1.1 × 6%)
Alpha = 12% − (10% + 6.6%)
Alpha = 12% − 16.6%
Alpha = -4.6%

In this example, the XYZ Fund has an Alpha of -4.6%, meaning it underperformed its benchmark by 4.6%. This indicates that the fund manager’s decisions did not add value compared to the benchmark index.

Leveraging Alpha in investment strategy

Alpha can be a valuable tool in your investment strategy. By analysing Alpha, you can identify which mutual funds are likely to provide better returns relative to their benchmarks. Here are some tips to use Alpha effectively:

• Compare Alphas: Look at the Alpha of different mutual funds to see which ones have consistently higher Alphas. This can help you identify skilled fund managers.
• Historical performance: Evaluate the historical Alpha of a fund. A fund with a consistently positive Alpha may potentially be a better choice.
• Risk assessment: Consider the Beta along with Alpha. A high Alpha with a reasonable Beta suggests good performance without excessive risk.
• Diverse portfolio: Use Alpha to diversify your investments. Don’t rely on Alpha alone but use it with other metrics to build a balanced portfolio.

Conclusion

Understanding and using Alpha can help you make better investment decisions when evaluating mutual funds. Alpha provides insight into a fund manager’s ability to add value beyond market movements. By incorporating Alpha into your investment strategy, you can identify mutual funds that are likely to offer superior performance.

FAQs

How does Alpha differ from other measures like Beta when evaluating mutual funds?

Alpha measures a fund's performance relative to a benchmark, indicating added value, while Beta measures a fund's volatility compared to the market.

Can Alpha provide insight into a fund manager's investment strategy?

Yes, Alpha can reveal the effectiveness of a fund manager's investment decisions by showing how much value they add beyond the market trends.

What are some common misconceptions about Alpha in mutual fund analysis?

A common misconception is that a high Alpha always means better performance. It is essential to consider Alpha in conjunction with other metrics like Beta.

Is higher Alpha always better, or are there scenarios where lower Alpha is preferable?

Higher Alpha is generally better, but it should be evaluated with other factors like risk (Beta) and the consistency of performance over time.

How reliable is Alpha as an indicator of future fund performance?

While Alpha is a useful measure, it is not a guarantee of future performance. Alpha is best used alongside other indicators to make informed investment decisions.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully. This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.