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Beta
Beta measures the relative risk of a fund or portfolio in relation to the market portfolio. In other words, it reflects the systematic risk associated with the fund. The market index has a beta of one. A beta higher than one means the fund is riskier than the benchmark and a beta less than one indicates lesser volatility than the benchmark. A beta of 1.1 implies that the fund has a volatility that is 1.1 times the benchmark volatility.
Volatility is not necessarily a bad thing. All that a beta suggests is that if the underlying stocks in an equity fund are chosen in such a way that their cumulative beta is say 1.2, if the market benchmark goes up by 10%, you should expect this fund to go up by 12% and conversely, if the market benchmark were to decline by 10%, you should expect this fund to decline by 12% : by 1.2 times the movement of the benchmark.
Beta is found out using regression and may be expressed as the covariance between the fund and the benchmark divided by the variance of the benchmark. A high beta is associated with a higher return.
In a bullish market, investors should select a fund with higher beta as likelihood of higher returns for taking higher risk are more. While in a bearish market, a fund with lower beta would be more appropriate as it is defensive against the market.
If you expect markets to be bearish, you would like to look for funds that have a low beta - which can provide you relative protection in market corrections and fall perhaps less than the market.
Alpha
Alpha represents the difference between the fund's actual return and the expected return, given the fund's beta. It is basically a measure of outperformance. A positive alpha implies that a fund has outperformed its benchmark index. An alpha of 2 would indicate that a fund has provided 2% higher returns than the market while an alpha of -2 would indicate that the fund has produced 2% lower returns than its market benchmark. A positive alpha is what one seeks. Here we talk about equity funds and alphas are most suitably used for these stock funds. Mathematically, alpha is measured as:
Alpha (?) = (Actual return of fund - risk free return) - beta of fund*(benchmark return - risk free return)
Working for a one year performance period:
Illustration:Actual return of fund: 30, Risk free return: 8%, Beta of fund: 1.1, Benchmark return: 20%
? = (0.30-0.08)- 1.1*(0.20-0.08) = 0.088 i.e. The fund has outperformed the benchmark index by 8.8%
Alpha represents the value added to a fund by superior stock picking skills of the fund manager.
We have briefly talked about the alpha and beta as measures of evaluating an equity fund. However, these measures will be mere misnomers if a proper benchmark is not present.
Illustration of ? and ?: Consider a fund A and the benchmark B. Let their returns for ten years be as follows:
Using the above information and the formulas, we arrive at a ? of 1.54 and ? of 4.6%. This implies that if the return on market portfolio increases by 1% , the fund's return will increase by 1.54%. Also, the fund has generated a return of 4.6% over and above the market return.
Alpha versus beta
Firstly, for performance evaluation, it is imperative to have the right benchmark for comparison. For instance, for large cap funds, you should compare them versus the Nifty or Sensex while for multi-cap funds, a comparison versus BSE 200 may be more appropriate.
Having selected the right benchmark, the question arises as to which measure to be used for evaluating the performance. This is dependent on the views and the requirements of the investor.
If an investor is looking to cash in on a bullish momentum that he expects in the market, ascertaining the beta of various short listed equity funds would help him choose the right vehicle to participate in the expected market action. Here, more than stock picking abilities of a fund manager - whose results may show up over time - the investor is really looking for a portfolio filled with "high momentum" stocks, which can outperform the market in the near term in bullish phases. A fund with a high beta would be well positioned to do the job for him. Many of the "Opportunities" funds in the market are constructed with beta greater than 1.
If on the other hand, the investor believes that mispricing persists in the markets and that markets are not very efficient, he would look for an actively managed fund which can find these "mispriced" opportunities and make more money over time than the market. This is the "alpha" that the fund manager seeks to achieve - a return in excess of market returns - which is primarily attributable to his superior stock picking skills.
Actively managed funds usually cost more than passive funds. The expense ratio of an index fund (a passive fund) is usually 1% while most actively managed funds cost upto 2% p.a. The fund manager's alpha should be sizeably higher than this incremental cost, for it to be worthwhile for the investor to take the incremental risk and bear the incremental cost.
Having said that, alpha is a true measure of stock picking ability of a fund manager. There are two ways of evaluating the performance of a fund manager who has delivered alpha returns on the fund. One is to simply look at the amount of alpha generated and measure the outperformance of the fund over its benchmark. Second is to measure the incremental return produced for a fund at a given beta. In the illustration discussed earlier, beta was assumed to be 1.1. However if we assume beta to be 1.4, alpha is reduced to 5.2 %.This will lead one to analyze the fund managers stock picking ability and the incremental proportion of alpha returns delivered by him that are over and above the momentum based returns.
In conclusion....
If an investor desires alpha returns, it is indispensable for him to do his homework well to find out the right fund manager with the right abilities. This can be done by evaluating the past performance of a fund manager and the alpha he has delivered over the incremental expenses over a long period of time. Though, this track record may provide a hint to the upcoming performance, it is no guarantee for high returns.
According to a study conducted by Jane Li (2009), active managers generated more real alpha in bull markets and lower real alpha in bear markets. Her other observations were that one should not paint either active or passive investments with a broad stroke. Both types of investments have their strengths and weakness. It depends on the market segments they are in: less efficient, more active.
In view of the above discussion, we can say that which measure is to be used depends on the investor belief and his objectives. Also, his returns depend on his ability to select the fund manager suited to his requirements. If near term momentum is your primary concern (upwards or downwards), beta is a better measure for you to focus on. If long term outperformance and wealth creation are your primary concerns, the ability and track record of the fund manager in delivering alpha is what you should be focussing on.
Share your thoughts and perspectives
Do you have any observations or insights or perspectives to share on this issue? Did this help you understand the topic better? Do you disagree with some of the observations? Please post your comments in the box below ..... it's YOUR forum !
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