Why Alpha and Beta are important when investing in mutual funds
When calculating risk and returns mutual funds, alpha and beta are the two most commonly used measurements to understand how successfully a portfolio has performed, when compared to its peers. Mutual fund investments do come with various types of risks.
Though there is a fund manager to help you earn profits, he cannot always anticipate risks due to global macroeconomic or political conditions which may butt in a fund's returns. There are different ways or statistical measures to measure risk and returns but alpha and beta are more commonly used.
Both alpha and beta help you understand how effective investments in the markets are as they help to track how profitable or unprofitable a fund has been.
Alpha is an acute barometer which indicates how much returns a fund has given compared to its benchmark. If the alpha shows a negative figure it means the scheme has underperformed the benchmark.Let’s understand through an example. If a large-cap scheme delivers 10% and its benchmark delivers returns of 5%. Here the scheme delivered 5% higher returns than the benchmark thus the excess return is the ?alpha? which the scheme generated over a period of time. Now let’s say another scheme delivers 5% whereas the benchmark delivers 15%. In this situation, it is clear the scheme failed to keep pace with the benchmark’s returns. A situation like this leads to various speculation and serious possibilities where the market could be in a bear phase or may have reacted due to external macroeconomic situations thereby making investible ideas challenging. Sometimes fingers are raised on the fund manager’s ability to deliver returns or boost profits. Beta visibly indicates the fluctuation and sensitivity of a scheme to market movements or the benchmark. It clearly defines the extreme ups and downs in prices which isn’t something an alpha can measure. So beta defines how closely a fund is related to the index and a beta accuracy leads to an accurate alpha.