Alpha

Have you wondered how to use alpha with mutual funds? Have you heard of alpha? You may already know that choosing the best mutual funds is actually a process of choosing the best fund managers. Alpha can help you do just that. As Morningstar says, "Alpha is a measure of the difference between a portfolio's actual returns and its expected performance, given its level of risk as measured by beta." In translation, alpha is the value added to (or subtracted from) a mutual fund's performance by the manager. A measure used primarily for actively-managed funds, alpha gives the investor a reasonable expectation of a fund manager's skill in selecting a fund's holdings that will hopefully perform better in relation to similar funds for the same or lower level of risk.

Of course, an investor must remember the classic caution that past performance is no guarantee of future results but investors who want to know how to choose the best funds must overlook this caution and make smart, calculated choices. If you like to use quantitative, statistical measures be sure to also check out Beta, R-squared andSharpe Ratio. If you're not a "quant" and you want to take the low maintenance route, you may want to check out index funds.

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5 Ways To Measure Mutual Fund Risk

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There are flashy numbers of dividend pay outs in percentages declared by fund houses on a regular basis in newspapers, periodicals, websites, etc. These numbers attract investor eyeballs towards their schemes. Now, SEBI has stepped in and has asked fund houses to disclose their pay outs in rupee terms. This shows that investors are trying to get a clearer picture on their investment returns through dividends. However, investing bySYNDICATION considering only historical returns and dividends in a mutual fund scheme is risky. Investors need to evaluate the risk involved in mutual fund schemes before investing and review their investments, say, at least once a year. Investors may perform a small 5-step exercise to evaluate riskiness of particular mutual fund scheme, as described below We will take a hypothetical example of ABC-Equity (G) scheme to compute its riskiness in our Paanch Ka Dum (Power of 5)concept:1) Alpha:
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Alpha basically is the difference between the returns an investor expects from a fund, given its beta, and the return it actually produces. Computation: Alpha = {(Fund return-Risk free return) (Funds beta) *(Benchmark return- risk free return)}. Example-1: Fund return (Fund performance in last one year) 75% Risk free return 8% Benchmark return (Sensex performance in last one year)41% Beta 0.69 By computing with above formula we will get alpha as 0.44 for this

fund. A positive alpha means the fund has outperformed its benchmark index. Whereas, a negative alpha indicates an underperformance of the fund. The more positive an alpha the healthier for investors. Here, the fund has underperformed since an alpha we computed is less than beta. It means fund has produced less returns considering the risks fund is taking while comparing it with actual return to the one predicted by beta. Note: The ideal time period for analysing alpha and beta value is one year returns from their funds. 2) Beta: Beta is a measure of the volatility of a particular fund in comparison to the market as a whole, that is, the extent to which the fund's return is impacted by market factors. Beta is calculated using a statistical tool called regression analysis. By definition, the market benchmark index of Sensex and Nifty has a beta of 1.0. It may be challenging for investors to compute it for each mutual fund scheme. However, one need not worry. Important statistical measures for various mutual fund schemes are easily available on financial websites like InvestmentYogi where mutual funds performance is tracked and analysed regularly. Let us consider 3 possible scenarios in interpreting beta numbers: [Sensex is assumed as benchmark index].
1.

A beta of 1.0 indicates that the fund NAV will move in same direction as that of benchmark index. The fund will move up and down in tandem with the movement of the markets (as indicated by the benchmark)

2. 3.

A beta of less than 1.0 indicates that the fund NAV will be less volatile than the benchmark index. A beta of more than 1.0 indicates that the investment will be more volatile than the benchmark index. It is an aggressive fund that will move up more than the benchmark, but the fall will also be steeper.

For example, if the beta of ABC-Equity (G) is 1.4 - then its considered as 40% more volatile than the benchmark index (beta of benchmark index being 1). Similarly, in example-1, as we have considered beta of ABC-Equity (G) fund as 0.69 - this means the mutual fund scheme will be less volatile than its benchmark index. Note: Conservative investors should focus on mutual funds schemes with low beta. Aggressive investors can opt to invest in mutual fund schemes which have higher beta value for higher returns taking more risk. 3) R-Squared: As discussed above, beta is dependent on correlation of a mutual fund scheme to its benchmark index. So, while considering the beta of any fund, an investor also needs to consider another statistic concept called R-squared that measures the correlation between beta and its benchmark index. The beta of a fund has to be seen in conjunction with the R-squared for better understanding the risk of the fund. R-squared values range between 0 and 1, where 0 represents no correlation and 1 represents full correlation. If a fund's beta has an Rsquared value that is between 0.75 and 1, the beta of that fund should be trusted. On the other hand, an R-squared value that is less than 0.75 than it indicates the beta is not particularly useful because the fund is being compared against an inappropriate benchmark index. This fund will not give returns similar to their benchmark index. The lower the Rsquared the less reliable is the beta, and vice versa. The R-squared of an index fund, investing in same securities and in the same weightage as the index, will be one. Note: Beta and R-squared are calculated based on the historical data. They give an adequate estimate of risks to be evaluated by investors before investing. 4) Standard Deviation (SD): The total risk (market risk, security-specific risk and portfolio risk) of a mutual fund is measured by Standard Deviation (SD). In mutual funds, the standard deviation tells us how much the return on a fund is deviating from the expected returns based on its historical performance.

In other words can be said it evaluates the volatility of the fund. The standard deviation of a fund measures this risk by measuring the degree to which the fund fluctuates in relation to its average return of a fund over a period of time. In other words, it is a measure of the consistency of a mutual fund's returns. A higher SD number indicates that the net asset value (NAV) of the mutual fund is more volatile and, it is riskier than a fund with a lower SD. Note: For SD to be an effective tool, investors will need to use it in comparison with peer group mutual funds. For example, a large-cap mutual fund is to be compared with a large-cap mutual fund with the same investment objective(s). 5) Sharpe Ratio: Sharpe ratio (SR) is another important measure that evaluates the return that a fund has generated relative to the risk taken. Risk here is measured by SD. It is used for funds that have low correlation with benchmark index. This ratio helps an investor to know whether it is a safe bet to invest in this fund by taking the quantum of risk. The higher the Sharpe ratio (SR), the better a funds return relative to the amount of risk taken. In other words, a mutual fund with a higher SR is better because it implies that it has generated higher returns for every unit of risk that was taken. On the contrary, a negative Sharpe ratio indicates that a risk-free asset would perform better than the fund being analyzed. It tries to find out the excess return generated by a mutual fund over and above a risk-free rate of return such as an RBI bond or a post-office savings scheme, etc. Lets say the Sharpe ratio = 0.957 for a fund. As discussed above, the higher this ratio, the better a funds return relative to the amount of risk taken. Here, this fund could be a risky investment option for their investors since ratio is just near to 1 (approx.). Quick View Mutual Fund Evaluation Criteria Consistent Performer -> Low SD; High SR -> Higher ranked fund

Volatile Performer -> High SD; Low SR > Lower ranked fund Mutual Fund Evaluation Criteria:Consistent Performer -> Low SD; High SR -> Higher ranked fund Volatile Performer -> High SD; Low SR -> Lower ranked fund Note: Comparison should be made with peer group for accurate evaluation. Conclusion: This Paanch Ka Dum concept we just discussed to evaluate a mutual funds risk will enable an investor to take a wise decision on his mutual fund investments. An investor should not blindly invest by considering only past returns mentioned, but needs to do some research of the fund schemes and reviewing their performance at regular intervals. These risk measure are readily calculated and are available on financial websites and research reports. For example, you can logon to www.investmentyogi.com and click on the mutual fund tab to look for the fund you wish to evaluate. You will find the latest data for all these parameters (under returns tab of a particular fund). However, the above measures cannot be viewed in isolation while evaluating the risks of investing in a mutual fund scheme. Other important parameters such as the corpus held, disclosure norms followed by the AMC, portfolio composition, consistency in investment objectives and strategy must also be considered. Written for InvestmentYogi by Hiral Thanawa
Published Jul 05 2010, 04:58 AM by Yogi

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Comments
Comments Prof. Haridas said:
July 6, 2010 2:58 AM

Very informative article

Minal said:

Nicely explained...
July 6, 2010 6:38 AM

Mohan Late said:

Hi Hiral, Great article ! Couple of questions 1. Are the above 5 risk measurement parameters provided by M.F. houses on their site or application form? 2. Are there any online tools which can help compute these 5 values? Thanks and keep up the good work! Mohan
July 7, 2010 5:51 AM

Prashant Thakkar said:

Great One. Very Useful to monitor Risk & Returns. For mohan, This ready data for MF Schemes available on Value Research.
July 7, 2010 11:14 AM

Raman said:

@Mohan, Please read the last paragraph of the article. I checked it out. Great article. Keep it going Yogi!
July 8, 2010 12:06 AM

Mukesh Pandya said:

Dear Hiral, Te article is as per your reputation in the field. It is simple and informative.
July 11, 2010 10:54 AM

R Bhattacharya said:

I am very impressed with the explanation provided in easy to understand language.

August 15, 2010 9:42 AM

vinayaka ravi kiran said:

That was really a useful information through which a lay man also starts investing in mutual fund
September 23, 2010 8:32 AM

vijai babu said:

nicely explained gives a basic idea who dont know anythng

December 12, 2010 9:29 AM

U.Muthuraj said:

Super explanation...Its very nice article...Its use for my MBA Summer Mutual fund project.....Thank you...
May 15, 2011 9:50 PM

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