Alpha in Mutual Funds- What is Alpha for Mutual Funds

The most vital factor of an investment is the returns. Investors review the returns history of the fund to decide if they should invest in or not. The growth or fall of a fund is monitored to understand it's past performance and how it might perform in the future. Also, a fund's risk plays a significant role. There are some indicators such as Alpha, Beta, Sharpe ratio, standard deviation, etc. that can assist an investor in studying the fund's performance in the market.

The ratios predict the investment's returns and how the market's movement can impact it. They also help in understanding the risk of investment and realise how good or bad a fund can perform against the market's benchmark.

One such ratio that evaluates the returns of an investment is Alpha.

What is Alpha in Mutual Funds?

Alpha is a ratio that denotes returns of a fund against the returns of the market. It predicts and compares the returns of investment while understanding the risk. It is a commonly used indicator by many investors to study the returns of a fund. Alpha in mutual fund indicates the risk of investment too.

The benchmark index performance after evaluating the risk is compared to the volatility of a fund to understand Alpha's indictor. Alpha denotes the value of a fund. It is the excess return of an investment in comparison to its benchmark index. When the Alpha ratio is higher than 1.0, it denotes how better it has outperformed compared to its benchmark index. Meanwhile, when the Alpha ratio is below 1.0, it indicates that the fund has underperformed in comparison to its benchmark index.

Example of How Alpha Indicates Performance of a Mutual Fund

Here are two examples of how Alpha indicates the performance of a fund-

  • You invest in a mutual fund BSE Sensex as the benchmark. BSE Sensex saw a rise of 20% in a year while the Alpha value of your fund was 4.0. In such a case, your fund has surpassed its benchmark index by 4% and has given you 24% returns that year.

  • You invest in a mutual fund when the BSE Sensex has a rise of 10%. But your fund has an Alpha below 0 of 2.0. In such a situation, your fund has underperformed, and the returns as the returns are only 8%.

You might get the same returns as the market if the value of Alpha is 0. The Alpha value above 0 denotes that a fund has outperformed its benchmark index while an Alpha value below 0 indicates that a fund has underperformed. You might get returns of 4% if the Alpha ratio is above the benchmark index by 4.0. Meanwhile, you will see 4% decrease if the Alpha ratio is below the benchmark index by 4.0.

Alpha indicates the value your fund can get you for your investment. The returns of an investment can be predicted when you study the Alpha value of a mutual fund with. You can get better returns if the value of Alpha is high. Alpha denotes a fund's performance in the market. But, Alpha is not the only indicator that denotes a fund's returns. There are some difficulties when you study returns with the value of Alpha. It indicates the performance of a fund in comparison to the benchmark index of the market. But different markets have different benchmarks. Ensure that you study the market when you are investing in a fund.