What are Alpha and Beta in Mutual Funds?

When choosing mutual funds, focusing only on returns can be misleading. Two funds can deliver similar returns over the same period, yet one may take far more risk to achieve them. This difference often goes unnoticed unless you look beyond returns. That’s where alpha and beta come into effect.  

Alpha and beta are used by investors to measure how a mutual fund performs in relation to market movements and risk. These metrics are especially useful when comparing large-cap, mid-cap, and equity mutual funds.

We explain in this blog what alpha and beta are in mutual funds, how they function, and how to calculate them, so you can feel more empowered when it comes to evaluating your investments. 

What Are Alpha and Beta in Mutual Funds?

Alpha and beta are critical risk-adjusted performance measures for assessing mutual funds. 

Alpha measures a fund’s ability to generate returns that exceed its benchmark’s. On the other hand, beta measures a fund’s sensitivity to overall market movements. 

Together, alpha and beta help investors evaluate the quality of a fund’s performance. 

Read About: Large Cap vs Mid Cap vs Small Cap Stocks

What Is Alpha in a Mutual Fund?

Alpha in a mutual fund represents the additional return a fund generates compared to its benchmark, after adjusting for risk. It also helps in reflecting the fund manager’s skill in selecting securities and timing the market.

• A positive alpha indicates the fund has outperformed its benchmark.
• A negative alpha suggests underperformance.
• An alpha of 0 means the fund has tracked the benchmark.

Alpha Ratio in Mutual Funds

The alpha ratio in mutual funds is particularly useful when comparing funds within the same category, such as large-cap or mid-cap funds. A higher alpha points to a fund manager’s ability to consistently generate excess returns. 

However, one should never evaluate alpha in isolation. A fund may show high alpha but also carry excessive risk, which is why beta also needs to be taken into account as well. 

Example of Alpha in Mutual Funds

Assume:

• Fund return: 14%
• Benchmark return: 12%
• Risk-free return: 6%
• Beta: 1
  

Expected return = 6% + 1 × (12% – 6%) = 12%
Alpha = 14% – 12% = 2%

This means the fund has generated a positive alpha of 2%, indicating superior performance.

What Is Beta in a Mutual Fund?

Beta in mutual funds measures how much the fund’s value fluctuates in response to market movements. It is a measure of market-related risk.

• Beta = 1: Fund moves in line with the market
• Beta > 1: Fund is more volatile than the market
• Beta < 1: Fund is less volatile than the market
  

Beta Ratio in Mutual Funds and Risk Assessment

The beta ratio in mutual funds are useful to investors in assessing suitability based on risk tolerance. A high-beta fund may deliver higher returns during bull markets but can fall sharply during market downturns.

Beta is especially relevant in equity categories such as mid-cap funds, which typically exhibit higher beta than large-cap funds.

How to Calculate Beta? 

Beta Calculation Formula

To understand how to calculate beta, the simplified formula is:
Beta = Covariance of Fund Returns and Market Returns / Variance of Market Returns. 

In practice, investors do not need to calculate beta manually. It is published in fund fact sheets and available on financial platforms. 

Example of Beta in Mutual Funds

If a mutual fund has:

• Beta of 1.2 → It is 20% more volatile than the market
• Beta of 0.8 → It is 20% less volatile than the market
  

This insight helps investors align fund selection with their risk appetite.

Alpha and Beta Across Large Cap and Mid Cap Funds

Large Cap Funds

Large-cap funds usually invest in established companies and often have:

• Lower beta
• More stable returns
• Moderate alpha over more extended periods
  

Mid Cap Funds

Mid-cap funds tend to:

• Have a higher beta
• Experience sharper market swings
• Deliver higher alpha during bullish cycles
  

How Investors Should Use Alpha and Beta Together

Alpha and beta should not be viewed in isolation. Instead, they should be used together to help provide a clear picture of fund performance.

• High alpha with reasonable beta indicates efficient risk-adjusted performance.
• High alpha with very high beta may involve excessive risk.
• Low beta with negative alpha may indicate conservative performance. 

Beyond Alpha and Beta: Key Ratios That Strengthen Mutual Fund Analysis

Beyond alpha and beta, there are other ratios that enhance mutual fund analysis.

Let’s look at them. 

• Standard deviation quantifies return variability from the mean, thereby highlighting volatility. 
• Sharpe ratio helps in evaluating risk-adjusted returns by subtracting the risk-free rate from average returns, divided by standard deviation. 
• The Price-to-Earnings (P/E) ratio compares a fund unit’s price to its earnings per share, aiding valuation.
• R-squared measures how closely fund returns follow the benchmark, with values from 0 to 1. Closer to 1 means a strong correlation, complementing beta.

These ratios, combined with alpha and beta in mutual funds, offer a holistic view for comparing funds.

Conclusion

Alpha and beta facilitate mutual fund investors look beyond returns and understand what’s happening beneath the surface. Alpha shows how well a fund performs compared to its benchmark, while beta highlights how sensitive the fund is to market movements, giving you reassurance about risk management.

When used together, these two metrics help in offering a clear view of both performance and risk. 

Alpha and Beta in Mutual Funds – FAQs

Disclaimer: Investments in the securities market are subject to market risks; read all the related documents carefully before investing.