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Doyouknowthedifferentperformanceparametersofequitymutualfunds:AlphaandBeta
May5,2017byDwaipayanBose(https://www.advisorkhoj.com/aboutus/team) | 31Downloaded

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Inourpost,Doyouknowthedifferentperformanceparametersofequitymutualfunds:Part1(https://www.advisorkhoj.com/company/Sundaram
MutualFund/articles/Doyouknowthedifferentperformanceparametersofequitymutualfunds:Part1), we discussed various risk and risk
adjusted performance parameters of mutual funds. Let us do a brief recap of the various concepts discussed in the first part
(https://www.advisorkhoj.com/company/SundaramMutualFund/articles/Doyouknowthedifferentperformanceparametersofequitymutual
funds:Part1).Standarddeviationisameasureofdispersionofafundsreturnsinvariousperiodsfromitsaveragereturn.Standarddeviationisa
measureofvolatilityorriskofamutualfundscheme.Higherthestandarddeviation,higheristheinvestmentrisk.

SharpeRatioisameasureofriskadjustedreturnsofamutualfundscheme.AlimitationofSharpeRatioisthat,itdoesnotdistinguishbetween
goodvolatility(higherthanaveragereturns)anddownsidevolatility(lowerthanaveragereturns).SortinoRatio,alsoameasureofriskadjusted
returns,addressesthelimitationofSharpeRatio,bytakingintoaccountthedownsidevolatilityonly.Inthispost,wewilldiscusstwoveryimportant
performance parameters of mutual fund schemes Alpha and Beta. Though Alpha comes before Beta alphabetically, investors should first
understandtheconceptofBeta.

WhatisBeta?
Betaistheriskofastockormutualfundschemerelativetotherelevantmarketbenchmark.Betais,inmyopinion,amorerelevantriskmeasurefor
equity investors, compared to the risk measure we discussed in our post, Do you know the different performance parameters of equity mutual
funds:Part1(https://www.advisorkhoj.com/company/SundaramMutualFund/articles/Doyouknowthedifferentperformanceparametersofequity
mutualfunds:Part1),StandardDeviation.Whyisbetamorerelevantthanstandarddeviationforequityinvestors?Equityinvestorsunderstand(or
shouldunderstand)therisk/returnrelationshipandarewillingtotakerisksinordertogethigherreturns.

Different segments or sectors of the market have different risk grades and naturally the standard deviations of riskier segments/ sectors (e.g.
midcap,smallcapfundsetc)willbehigherthanthoseofthelessriskyones(e.g.largecapfunds).Differentmarketsegmentsandsectorshave
different market benchmarks, e.g. Sensex (for the largest 30 market cap stocks), BSE100 (for the largest 100 market cap stocks), BSE Midcap
Index(formidcapstocks),BSESmallCapIndex(forsmallcapstocks),Bankex(forbankstocks)etc.

https://www.advisorkhoj.com/company/SundaramMutualFund/articles/Doyouknowthedifferentperformanceparametersofequitymutualfunds:Alphaan 1/4
5/6/2017 MutualFundsIndia,FinancialAdvisorsinIndia|Advisorkhoj
Betabroadlytellsus,howmuchpricechange(forastockorfund)wecanexpect,ifthemarketbenchmarkmovesupordownby1%.Pleasenote
thatthisisonlyanapproximatedefinitionofBeta.TheexactdefinitionofBeta,forinvestorswhoaremoretheoreticallyinclined,isimplicitinthe
classicCapitalAssetPricingModel(CAPM):

Letusunderstandthisformulawiththehelpoftwoexamples.Assumethatyouhaveinvestedinalargecapfund,whosebenchmarkisBSE100.
Thebetaofthefundis2.Readersshouldnotworryabout,howtocalculateBeta.YouwillgettheBetaofamutualfundschemeinthefactsheetor
insomeofthemutualfundresearchwebsiteslikevalueresearchonline.com,morningstar.in,advisorkhoj.cometc.Forourreaders,whoaremore
mathematicallyinclined,betaiscalculatedbyrunningaregressionanalysisofdailyexcessreturnsofafundovertheriskfreerateversusthedaily
excessreturnsofthebenchmarkindexovertheriskfreerate.

Letusgetbacktoourexamplenow.Letusassumethattheriskfreerateis8%.IfBSE100risesby15%,thenasperCAPM,thereturnofyour
fundwillbe8%+2X(15%8%)=22%.Ontheotherhand,ifBSE100fallsby10%,thenasperCAPM,thereturnofyourfundwillbe8%+2%
X(10%8%)=28%.LetusnowassumethattheBetaofyourfundis0.8.IfBSE100risesby15%,thenthereturnofyourfundwillbe8%+0.8
X(15%8%)=13.6%.IfBSE100fallsby10%,thenthereturnofyourfundwillbe8%+0.8X(10%8%)=6.4%.Clearly,higherthebetamore
istheriskandviceversa.

Betaisaveryimportantconceptininvesting.Highorlowbetadoesnotimplyagoodorbadfunditsimplyindicatestheriskprofileofthefund.
Whenyouareinvestinginahighbetafund,youshouldbeconsciousoftheriskyouaretaking.Wehavediscussedanumberoftimesinourblog
that,youshouldinvestbasedonyourinvestmentobjectivesandriskappetite.Ifyouhaveanaggressiveriskappetiteandnaturallydesirousof
highreturnsthenyoucaninvestinhighbetafunds.Ifyoudonothaveahighriskappetite,youshouldchoosealowbetafund.

WhatisAlpha?
CapitalAssetPricingModel(CAPM)isoneoftheclassicfinancetheories,butcantheperformanceofamutualfundschemebealwaysexplained
by CAPM? The answer is no. CAPM assumes that a fund can give higher return only by taking more risks. In reality, however, some fund
managersareabletogivebetterreturnsthanotherfundmanagers,bytakingthesameamountofriskorevenlesserrisk.Inotherwords,returnsof
yourmutualschemesarenotjustdependentontheriskprofilesoftheschemes,butalsoonthevalueaddedbythefundmanagers.Alphaisa
measureofthevalueaddedbyyourfundmanager,forthesameamountofrisk.Inmathematicalterms,wehavetomodifytheCAPMformulato
accommodatethefundmanagersvalueadd.

Letusunderstandthisconceptbyrevisitingtheexamplediscussedearlier.Letusassumetheriskfreerateis8%.Letusfurtherassumethatyou
haveinvestedinafundwhosebenchmarkindexisBSE100andbetais2.IfBSE100risesby15%,howmuchreturncanyouexpectfromyour
fund?AsperCapitalAssetPricingModel(discussedearlier)youcanexpectareturnof22%fromyourfund.Letusassumeyougetareturnof
25%.Howdidyouget3%extrareturns?Itwasaresultofthevaluecreatedbyyourfundmanager.The3%isthealphaofthefund.WhatifBSE
100fallsby10%?AsperCAPMyourexpectedreturnwouldbe28%,butifyourfundmanagerisabletogeneratea3%alpha,youractualreturn
wouldbe25%.

From a conceptual standpoint, alpha is the excess return generated by your fund manager versus what is predicted by CAPM. You will get the
Alpha of a mutual fund scheme in the factsheet or in some of the mutual fund research websites like valueresearchonline.com, morningstar.in,
advisorkhoj.com etc. The top performing funds that have sustained their outperformance over a sufficiently long period of time are undoubtedly
fundswithhighalphas.Highalphaspeaksofthefundmanagersabilityofstockselectionandportfolioconstruction.

HowtouseAlphaandBetaforFundSelection?
NowthatweunderstandtheconceptsofAlphaandBeta,wecanputthemtousewhileselectingfundsforourmutualfundportfolio.Firstly,you
need to determine your investment objectives and risk tolerance level. Based on your risk tolerance level, you need to identify the category or
categoriesoffundsthatyouwillinvestinandtherelativeallocationstoeachcategory.Forexample,ifyouhaveahighrisktolerancelevelyoumay
have a higher allocation to small and midcap funds. On the other hand, if you have a lower risk tolerance level, your portfolio should be biased
towards large cap funds. Once you have determined your allocation to a particular category, you should select funds based on your investment
objectivesandriskappetite.Ifyouhaveanaggressiveriskappetiteyoucanselecthighbetafundsinthatparticularcategoryontheotherhandif
youarelessaggressiveandwantmorestabilityinyourportfolioyoushouldselectalowbetafundsinthatcategory.Ineithercase,you should
selectfundsthathavegivenhighalphas.Itisusuallyrecommendedthatyouselectmoderatebetaandhighalphafunds,butifyouhaveahigh
riskappetitethenyoucanselecthighbetaandhighalphafunds.

Conclusion

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5/6/2017 MutualFundsIndia,FinancialAdvisorsinIndia|Advisorkhoj
Inthispostwehavereviewedtwoimportantconceptsrelatedtomutualfundselection.Insteadofsimplylookingathistoricalreturns,youshould
lookattheAlphaandBetaofthefund.Betacanhelpyouidentifyfundsconsistentwithyourriskappetite,whileAlphawilltellyouwhetheramutual
fund scheme can outperform in the future, as long as the fund manager and the investment strategy of the scheme remain unchanged. Pay
attentiontoalphasandyouwillemergeasasavvierandmoresuccessfulinvestor.

MutualFundInvestmentsaresubjecttomarketrisk,readallschemerelateddocumentscarefully.

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DwaipayanBose

AnalumnusofIIMAhmedabad,DwaipayanisaFinanceandConsultingprofessional,with13yearsofmanagementexperience,mostlyinMNCslikeAmericanExpress
andAmeripriseFinancial,bothinIndiaandtheUS.Inhislastrole,hewastheChiefFinancialOfficerofAmericanExpressGlobalBusinessServicesinIndia.Hiskey
interestsarebuildingbestinclassorganizations,corporategovernanceandtalentdevelopment

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