Tuesday 25 June 2019
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Understanding Alpha

In mutual funds, alpha is a crucial barometer. Understanding alpha helps in understanding the soundness of one’s investments in a scheme. Typically, a scheme has an index against which its composition is benchmarked. For instance, a large-cap scheme could have a benchmark index as BSE 100. Now, consider two cases. One, in which the scheme delivers 15% and its benchmark BSE 100 delivers 10% returns in one year. In the second case, the same scheme delivers 10% and its benchmark index BSE 100 delivers 15%. In the first case, the scheme has delivered 5% higher returns than the benchmark. This excess return is the alpha the scheme has been able to generate. In the second case, the scheme has failed even to keep pace with the benchmark’s returns, which points to a variety of possibilities. There could be a possibility that the markets are in a bearish phase and spotting investible and profitable ideas has become difficult. There could also be a possibility that the fund manager has failed in capturing interesting ideas which would have boosted the returns. So, alpha means the excess returns a scheme generates over and above the returns its benchmark index has generated.

In understanding returns an important factor investors need to bear in mind is the concept of volatility. This could be understood in terms of a scheme. One aspect of volatility is associated with the scheme. It means how volatile is the scheme’s portfolio with respect to its average. And the other aspect of volatility is associated with respect to the markets, which is its benchmark index. This aspect of volatility is called Beta. One of the effective ways of understanding how a scheme fares holistically is taking into account both alpha and beta. If a scheme scores well on both these variables, then it becomes an attractive investment option.

Generating alpha has been the key challenge. In the past two years, a line of thought which is gaining currency among high networth individuals is attractiveness of passive funds in comparison with active funds. This is because a large number of equity schemes have been unable to generate alpha. This is one of the key reasons why HNIs are preferring to invest in exchange traded funds  to actively managed funds. In a cyclical phase of markets, such tactical shift happens. But when alpha is generated, an important aspect investors need to bear in mind is the category performance of the scheme. For instance, if a large-cap scheme does not generate alpha then it is important to look at the average return of all schemes in large-cap category. If the scheme you have invested generates higher return than the average return then it has served well as a profitable investment.




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