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Tuesday, March 1, 2016

Alpha of Mutual Funds

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It is the first letter of the Greek alphabet, but also an important tool when measuring fund performance.

Alpha is the difference between a fund's expected returns based on its beta and its actual returns. Alpha is sometimes interpreted as the value that a portfolio manager adds, above and beyond a relevant index's risk/reward profile. If a fund returns more than what you'd expect given its beta, it has a positive alpha. If a fund returns less than its beta predicts, it has a negative alpha.

Which brings us to beta. Beta measures an investment's volatility, or more specifically, its sensitivity to the movements of a market index. On days when a market index generates a positive return, a fund with a high beta would be expected to gain even more than the index. On the flip side, it would also be expected to lose more than the index during market downdrafts.

Here are 5 things to note about alpha.

1) Higher beta is not necessarily higher alpha.

Alpha attempts to show whether a fund has adequately compensated investors for its volatility level, as reflected by its beta. For example, a high-beta fund might have experienced extreme performance gyrations relative to its benchmark. But if its returns have been even higher than its beta would predict, the fund has generated positive alpha. A low-beta fund can also generate positive alpha by generating higher returns than its beta would suggest.

Bear in mind that a higher beta (higher risk relative to an index) does not necessarily equate to higher alpha (greater return for that risk); a high-beta fund may well sport a negative alpha. That's because the greater the risk the fund assumes, the higher the hurdle the fund must jump over in order to outperform the benchmark.

2) Same return need not mean identical alpha.

The starting point for calculating alpha is to find how much a fund and its benchmark have returned (on a monthly basis) over the return of a guaranteed risk-free investment such as a Treasury Bill. You then find the expected return for the investment by multiplying the fund's beta by the benchmark's excess returns. The difference between the fund's actual return and its expected return is its alpha. If alpha is positive, it means that the fund returned more than its expected return, whereas a negative alpha indicates that the fund returned less.

For example, let's say an equity fund generated an excess return of 10% in a given time frame and the Nifty generated an excess return of 8%. If the fund had a beta of 0.5, its expected return would be just 4%. (0.5 x 8%). But given the fund's actual excess return of 10%, the fund's alpha is 6% (10% - 4%).

Because alpha is determined by both a fund's return and risk, two funds could have the same returns but their differing risk levels will lead to two distinct alphas.

3) The legitimacy of alpha is dependent on beta.

Alpha is dependent on the legitimacy of the fund's beta measurement. After all, it measures performance relative to beta. So, for example, if a fund's beta isn't meaningful because its R-squared is too low (below 75), its alpha isn't valid, either.

In other words, both alpha and beta are of limited use if a fund doesn't have a high correlation to the benchmark to which it's being compared. That's why it's important to check that a fund has a high R-squared with a benchmark before putting any weight on its alpha or beta. If a fund has a low correlation with its standard index, its corresponding alpha statistic is not reliable, nor is the beta statistic from which the alpha is derived.

4) Alpha is not forward looking.

All modern portfolio theory, or MPT, statistics are based on an investment's past return history; alpha, like beta, is a backward-looking measure and its predictive ability is far from guaranteed.

A fund's high alpha may owe to actual managerial talent, but it could also be the result of a series of lucky stock picks or sector bets. Is that high-alpha manager a genius, or did he just stumble upon a few hot stocks? If it was simply luck, that positive alpha figure could become negative as soon as the hot streak ends.

5) Negative alpha is not always bad.

Additionally, alpha fails to distinguish between underperformance caused by incompetence and underperformance caused by fees. For example, index funds have negative alphas which usually reflect the drag of expenses, even when expenses are very low.

An index fund may be perfectly correlated with its benchmark (as indicated by a R-squared of 100 and a beta of 1), but its alpha could be negative. This is because index fund managers don't engage in stock-picking and hence, are neither adding nor subtracting a significant amount of value. But many index funds will have negative alphas because fees eat into returns. Having said that, these funds can still be worthwhile core holdings.

It is worth noting that just as a high-alpha doesn't provide airtight evidence of a fund's merit, one must not be too quick to cross negative-alpha funds off your list.

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