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What do we mean by Alpha from a fund managers perspective

You will find a lot of fund managers talking about Alpha generation. What exactly do you understand by Alpha when it comes to fund management? Let us start off with a fundamental question on why we invest our money in mutual funds. The idea is that the fund manager should be able to use his fund management skills, his team of traders and analysts to identify quality stocks at attractive prices. That is what generates returns more than the index over the long run. For example, if the Nifty generates 18% returns during the year and the fund manager also gives you returns of 18%, then there is no point in investing in an equity fund. You invest in an equity fund to earn more than what an index fund gives you. Otherwise, you are better off investing in a passive index fund and earning returns without any worries.

Let us understand what is alpha in finance and how to interpret alpha in finance. Alpha, in simple terms is the excess return that the fund manager earns compared to what he is expected to earn. That is alpha in investment management! That brings us to the next logical question; how do we decide what is the return that the fund manager is expected to earn. For that let us get back to a little bit about 2 key concepts of Beta and CAPM.

Beta and CAPM (without getting too technical)..
What do we understand by Beta? Beta is a measure of the systematic risk of a stock or a portfolio. When we talk of systematic risk we refer to risks that uniformly impact all stocks in the market. This systematic risk is important because this risk impacts all stocks and hence cannot be diversified away. For example, if you are holding Tata Steel and you expect the steel demand to slow down then that is a risk unique to the steel industry. That is an unsystematic risk and you can diversify that risk by exiting Tata Steel and investing in a non-steel stock. But how do you handle a risk like Lehman Brothers that impacts all stocks. That is systematic risk and cannot be diversified away. This systematic risk is measured by Beta.
As we saw earlier, alpha is the excess returns that the fund earns over and above what the fund is expected to earn. To calculate what the fund is expected to earn you use CAPM (Capital Asset Pricing Model). Here is what it says..

R = Rf + Beta x (Rm – Rf) + Alpha

R = Actual Return earned by the Fund
Rf = Risk free rate of return that you can earn on government bonds
Rm – Market return on the index
Beta – systematic risk (less than 1 is defensive and more than 1 is aggressive)

Therefore Alpha can be rewritten as follows

Alpha = R – {Rf + Beta x (Rm – Rf)}

What the beta here indicates is that a portfolio with a beta of 1.2 is 20% more risky than the market and a portfolio with a beta of 0.80 is 20% less risky than the market. So if you have a higher beta then the expected returns on your portfolio will be higher and if you have a lower beta then the expected returns on your portfolio will be lower.

How is Alpha useful to mutual fund investors?
Alpha clearly explains how much the fund is actually generating more than what it is actually expected to generate. For example there may be 2 funds which may have given returns of 22% and 29% in the last 1 year. Your obvious reaction will be to conclude that the fund that returned 29% is better than the fund that generated 22%. But the fund that generated 29% may have done so with a Beta of 1.5 while the fund that generated 22% may have generated with a Beta of 1.1. Alpha allows you to calculated risk-adjusted returns and that enables you to compare funds across the equity category on a comparable basis instead of trying to compare apples and oranges.

How is Alpha meaningful to fund managers?
The alpha holds a mirror to the fund manager’s performance after factoring in risk. The bottom-line is that it is the job of a fund manager to either generate the maximum level of return for a given level of risk or to minimize the risk for a given level of returns. Secondly, alpha may not be too relevant in a time span of 1 or 2 years. Mutual fund investments are meant for longer time frames like 5-10 years. Over such periods if the alpha is still zero or negative then it raises serious questions over the ability of the fund manager to beat the market in risk adjusted terms.

From a mutual fund investor’s perspective, there are times when most of the fund managers are generating zero or negative alpha. That is an indication to the investor that she may be better off investing in a passive index fund!

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