Understanding Alpha & Beta – By Prof. Simply Simple TM Are the risks you take in your investments worth it? Read on to understand how to use alpha and bets to understand the performance of your fund
Alpha is part of what is called modern portfolio theory – a set of techniques that analyze investing in a somewhat academic manner. Alpha is used along with beta and R-squared.
Beta is a measure of the sensitivity of the fund to its index Beta is a measure of the sensitivity of the fund to its index. It shows the relation between the funds returns and that of its index. A beta of 1.5 means that the fund tends to rise and drop 50 percent more than the index does.
A 1. 5 beta fund is more volatile than a fund with a beta of 1 A 1.5 beta fund is more volatile than a fund with a beta of 1. Beta is therefore a measure of volatility. You are taking a higher risk in investing in such a fund. Why would an investor take such a risk? Surely to be able to earn higher returns.
How would you know if the returns from a high beta fund are enough the justify the higher risk? That’s where alpha comes in. Alpha tells you whether the fund has produced returns justifying the risks it is taking by comparing its actual return to the one predicted by the beta. Say a fund, can be expected to earn, based on its beta, a return of 15%. However it actually fetches 18%. The alpha of the fund is 18-15=3.
Alpha can be seen a parameter of a fund manager's performance Alpha can be seen a parameter of a fund manager's performance. This is what the fund has earned over and above (or under) that is was expected to earn.
Index funds have or should have an alpha of zero Index funds have or should have an alpha of zero. Thus a passive fund has an alpha of zero and an active fund’s alpha is a measure of that the fund manager has contributed to the fund's returns. On the whole, a positive alpha implies that a fund has performed better than expected, given its level of risk. Higher the alpha, better are the returns.
Hope you have understood the concept of ‘Alpha and Beta’.
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Disclaimer The views expressed in these lessons are for information purposes only and do not construe to be of any investment, legal or taxation advice. They are not indicative of future market trends, nor is Tata Asset Management Ltd. attempting to predict the same. Reprinting any part of this presentation will be at your own risk and Tata Asset Management Ltd. will not be liable for the consequences of any such action.