Risk and return define the value of an investment. Typically, the more risks you take, the higher returns you may register. Now, you may want to measure the amount of risk you are taking and what returns you are generating in exchange. This can be done through many metrics and ratios, alpha being the most popular.
Alpha indicates how much excess return the investment has earned above its benchmark return, often also referred to as ‘abnormal rate of return’ or ‘excess return’. The term alpha is also used in investing in assessing the performance of a fund manager.
Let’s understand alpha as a metric in detail.
You will Learn About:
What is alpha?
Alpha is the absolute value at which the performance of security deviates from a benchmark index value. In other words, alpha is the excess returns that an investment records over its benchmark.
It can also be defined as the risk-adjusted return of a portfolio, stock or fund.
Portfolio managers who actively traded funds were required by investors to deliver returns in excess of what they expected to earn from passive index funds. Alpha is thus also used to assess how much return has the portfolio manager added by actively managing the portfolio.
Alpha is one of the standard performance metrics used to evaluate an investment portfolio or individual stocks. The other metrics include beta, standard deviation, R-squared, and the Sharpe ratio.
Alpha can either be positive or negative. A positive value indicates that the security has outperformed the market, and a negative alpha indicates that the security has generated a lower yield as compared to the benchmark index.
Return on equity: Highlights
- Alpha is the excess returns earned on investment above the benchmark return.
- A positive alpha is an indication of better performance as compared to its benchmark. A negative alpha, on the other hand, is an indication of a fund’s underperformance.
- The alpha of mutual funds can be calculated by using beta and risk-free rate values.
- Alpha is among five other standard performance metrics. These performance indicators help investors determine the risks and returns associated with an investment.
How to calculate the alpha of a stock?
You can use the formula given below to calculate alpha:
Alpha = R – ( Rf + Beta * (Rm – Rf))
Where the variables indicate the following:
R is the return on a portfolio,
Rm is the benchmark index or the return of the market
Rf is the risk-free rate of return
Beta is the risk factor of the portfolio
Let’s take an example of a portfolio to understand the alpha calculation. Suppose the actual return earned by the portfolio is 20%, and the beta is 1.1. 10% is the risk-free rate of return, and 15% is the benchmark index return.
Alpha would be calculated as follows:
Alpha = 0.20 – ( 0.10 + 1.1 (0.15 – 0.10))
= 0.20 – 0.155 = 0.045 = 4.5%
Alpha for mutual funds
Alpha helps measure risk-free returns, i.e. the return you can generate without taking any risk, which includes systematic and unsystematic risks. When concerning mutual funds, alpha helps define two things – How a fund manager has performed and how much a fund has outperformed its benchmark.
Alpha thus allows investors to make better and more informed investment decisions.
Here’s how you can read alpha values. Say your fund’s alpha is 4. The benchmark index against your fund has generated 8% returns. Then, this indicates that your fund has delivered a return of 12%. Now, assume your alpha is -1. Then taking the same example as above, your return is 7%.
Let’s read how to calculate the alpha value for mutual funds below.
How to calculate alpha in mutual funds?
You can determine alpha for mutual funds by calculating the excess returns over the benchmark. Generally, the baseline for alpha in a mutual fund is 0. If the value is below 0, it means that the fund has been underperforming in comparison to its benchmark. On the contrary, if it is higher than 0, it means that the fund has outperformed its benchmark. If the value remains zero, it can be concluded that the performance of the fund has been in line with its benchmark.
Let’s take an example. Assume that the benchmark return has been recorded as 6%, whereas the fund has recorded a return of 8%. Here, the difference between the benchmark return and fund return is 2, which is the alpha. As the value is positive and above 0, it can be concluded that the fund has outperformed the benchmark. Do you now observe how alpha can help determine the performance of a fund?
Alternatively, you can use the following formula to determine the alpha of a fund –
Alpha = (Mutual fund return – Risk-free return (Rf)) – [(Benchmark return – Risk-free return (Rf)) * Beta]
What is Nifty Alpha 50?
The index Nifty Alpha 50 was designed to track and measure the performance of stocks with high alphas. Elements such as market capitalisation and liquidity are taken into consideration for the selection of securities.
The alpha values of the Nifty Alpha 50 stocks are used to assign weights to stocks in the index. The security with the highest alpha in the index will have the highest weight. You can calculate the alpha of eligible securities by taking the trailing prices for 1 yr. The list of Nifty Alpha 50 stocks undergoes review after every 3 months. It uses data from the six months that end on the last trading day of February, May, August, and November.
The Nifty Alpha 50 index covers sectors such as Power, Oil and Gas, Financial Services, Telecom, Textiles, Chemicals, FMCG and more. The index can also be used for different purposes, including launching index funds, exchange-traded mutual funds, structured products, and benchmarking fund portfolios.
In conclusion
Alpha is a useful metric to calculate the return that actively managed portfolios, stocks or funds generates over and above their benchmark returns. It can be used by investors to decide which securities to invest in. At the same time, they can also use to assess a fund manager’s performance. Read alpha with other parameters and metrics before investing.
