By Parthajit Kayal and Malvika Saraf
Alpha and beta are two popular words used in the investment arena. However amateur retail investors may not have much familiarity with these terms. In this article, we would explain what are alpha and beta and how they are used to evaluate funds.
Alpha and beta are two statistical measures that are popularly used to evaluate the performance of an individual stock, mutual funds, or investment portfolios, and thereby generate superior returns.
What is alpha?
In mutual funds, alpha is a crucial barometer. Understanding alpha helps in understanding the soundness of one’s investments in a scheme. Typically, a scheme has an index against which its composition is benchmarked. For instance, a large-cap scheme could have a benchmark index as BSE 100. Now, consider two cases. One, in which the scheme delivers 15% and its benchmark BSE 100 delivers 10% returns in one year. In the second case, the same scheme delivers 10% and its benchmark index BSE 100 delivers 15%. In the first case, the scheme has delivered 5% higher returns than the benchmark. This excess return is the alpha it has been able to generate.
This alpha is achieved due to fund managers’ investment skill. In the second case, the scheme has failed even to keep pace with the benchmark’s returns, which points to a variety of possibilities. There could be a possibility that the fund manager has failed in capturing interesting ideas which would have boosted the returns. So, alpha means the excess returns a scheme generates over and above the returns its benchmark index has generated.
What is beta?
In understanding returns, investors need to bear in mind the concept of volatility. One aspect of volatility is associated with the scheme. It means how volatile is the scheme’s portfolio with respect to its average. And the other aspect of volatility is associated with respect to the markets, which is its benchmark index. This aspect of volatility is called beta. This is also known as correlation with the market.
A stock or portfolio is always correlated with the market benchmark index. If the benchmark index changes, the value of the stock or portfolio would also change. The baseline number for beta is one. This means the change in portfolio prices is exactly the same as the market moves. A beta of less than one means the change in portfolio prices is less than the market, while a beta greater than one specifies that the change in portfolio prices is more than the market.
Typically, fund managers would like to have high beta value when market is rising so that portfolio could beat the benchmark index and less beta value when market is falling to ensure portfolio fall is less than the market.
How to generate alpha using beta
Generating alpha has been the key challenge for the fund managers. In the past two years, many high net-worth individuals are preferring passive funds over active funds. This is because many equity schemes have been unable to generate alpha.
A skilled fund manager can use the idea of beta while making a portfolio to generate positive alpha. While the market is in a bull phase, it may be wise to give more weights on the high beta stocks in the portfolio to generate excess returns over benchmark index. Similarly, in the bear phase they should put more weights on low beta stocks to make the portfolio more defensive in order to protect it from sharp fall.
As discussed above, alpha and beta can be used to evaluate equity schemes. However, investors should not only focus on alpha and beta while making an investment decision. In a cyclical phase of markets, schemes’ performance may vary due to various reasons. Investors need to look at the performance of the other schemes from similar categories. For instance, if a large-cap scheme does not generate alpha then look at the average return of all schemes in the large-cap category. If the scheme you have invested in generates higher return than the average return, then it has served well as a profitable investment.
Kayal is assistant professor, Madras School of Economics and Saraf is a recent graduate, Madras School of Economics