There are many factors that help an investor to analyse the mutual fund before deciding to invest in it. Alpha is one of such indicators that shows the fund’s performance. It can be either positive, zero, or negative based on the performance in comparison with the market.
The purpose of alpha is to measure the value a fund manager adds (or subtracts) relative to a benchmark after adjusting for risk, thereby helping investors assess the manager’s effectiveness and hold them accountable for performance. This article will give you a detailed explanation of alpha and if as an investor it is important for you.
What Is Alpha?
When risk is taken into account, alpha indicates how much better (or worse) a mutual fund has done than its benchmark index. Consider it a scorecard for the choices made by the fund manager.
- To put it simply, your fund has outperformed the market if the alpha is positive.
- Your fund has performed no better than the market if Alpha is zero.
- Even though you took a risk, your fund has underperformed if Alpha is negative.
Key Features:
- Risk-Adjusted: Takes into account not only performance but also returns in relation to the risk assumed.
- Fund Manager Effectiveness: Emphasises the value that active fund management adds, or doesn’t.
- Comparative Tool: Assists in comparing funds with comparable returns by displaying which performed better under the same risk.
- Best When Used with Other Metrics: Performs well when combined with expense ratio, beta, and Sharpe ratio.
- Needs Consistency: Consistent, positive Alpha over time is more important than one-time spikes.
Why Should You Care About Alpha as an Investor?
Alpha is an essential indicator, but as an investor, is it beneficial for you? Let us know:
1. It Displays Fund Manager Proficiency
Management fees are assessed by mutual funds, particularly those that are actively managed. You have a right to know as an investor whether the manager is outperforming the market or merely matching it.
- When risk is taken into account, a positive alpha indicates that the manager outperformed the benchmark.
- A negative alpha indicates that, despite taking on risk, the manager was unable to even match the market.
2. It Aids in Distinguishing Manager Performance from Market Performance
Markets can occasionally soar, and almost all funds are exhibiting strong returns. However, this does not imply that all funds are outperforming the market.
Alpha separates the noise and indicates whether those gains are the result of wise investment choices or if everyone is getting better off.
3. It Enables More Intelligent Comparisons of Similar Funds
Alpha assists you in determining which of two or more funds with comparable returns performed better in relation to their risk and benchmark.
| Metric | Fund A | Fund B |
| Return (%) | 10 | 10 |
| Beta | 1.1 | 0.9 |
| Alpha (%) | +1.5 | -0.2 |
4. It Encourages the Development of Long-Term Wealth
You want funds that beat the market over an extended period of time, not just during a bull run, if you’re a long-term investor. You can identify funds that have produced consistent, risk-adjusted returns by tracking Alpha over a number of years. This is crucial for long-term wealth accumulation.
Limitations of Alpha and What Else to Consider
Now, let us understand the limitations associated with the alpha:
1. Unreliable in brief periods of time
Over brief intervals, alpha can change dramatically. A fund that exhibits a high Alpha this year may not continue to do so next year. A one-time outperformance could just be the result of timing or luck rather than skill.
2. Not Consistent
Alpha doesn’t reveal the consistency or volatility of those returns; it only provides information about historical performance in relation to a benchmark. A fund may perform inconsistently despite having a high Alpha.
3. Aware of the Selection of Benchmarks
The chosen benchmark affects Alpha’s accuracy. The Alpha value becomes deceptive if the incorrect benchmark is applied, such as when contrasting a small-cap fund with a large-cap index.
4. Ignores Other Important Factors
Other crucial elements like fund costs, liquidity, portfolio quality, and market conditions are not taken into consideration by alpha. Even though a fund has a high Alpha, it may still be costly or risky.
Bottomline
The conclusion can be drawn that alpha may be an important indicator of performance, but this is not the ultimate measure. It helps the investor to analyse how a fund manager is managing the fund. The measure of alpha shows if the fund outperformed or underperformed the market. However, it may be unrealistic in the short term and ignore other factors like liquidity.
The investor cannot rely on it directly as it may be misleading. It is important to analyse other factors as well for sound decision-making.