What is Alpha in Mutual Funds?

Alpha measures an Fund performance relative to a benchmark index, indicating the excess return achieved beyond what was expected based on the investment’s risk. It is a crucial indicator of how effectively a fund manager has performed in generating returns that exceed the market's average, given the level of risk taken.
 

Understanding Alpha

Alpha is a key performance metric used to evaluate an investment's returns compared to a benchmark indexIt shows how well an asset or fund has performed relative to the expected return based on its risk profile. 

An alpha value of zero means the mutual fund has performed in line with the benchmark. Positive alpha indicates outperformance, while negative alpha suggests underperformance. This measure helps investors assess whether the fund manager has added value through their investment decisions. 

For instance, if a mutual fund has an alpha of 2, it means the fund has outperformed its benchmark by 2%, demonstrating the Fund manager’s ability to generate additional returns beyond market expectations.
 

How to Calculate Alpha in Mutual Funds

To calculate alpha in mutual funds, you can use two methods:
1.    Direct Calculation: 
The alpha of a mutual fund can be computed using the formula:
(End Price + DPS – Start Price) / Start Price
Here, DPS stands for Distribution per Share. This formula provides the excess return of the fund compared to the initial investment.

2.    Using CAPM: 
Alpha can also be derived using the Capital Asset Pricing Model (CAPM). CAPM estimates the expected return based on the fund's risk. The alpha is the difference between the actual return and the expected return predicted by CAPM. 

For example, if an Equity Linked Savings Scheme (ELSS) fund’s CAPM indicates an expected return of 5%, but the fund returns 9%, the alpha is 4%. This indicates the fund manager has delivered returns 4% higher than what was anticipated.
 

Example of Alpha

Consider a hypothetical mutual fund with a starting price of ₹100 and an ending price of ₹120. During this period, the fund also distributed ₹5 per share as dividends. 

To calculate the alpha using the formula:
Alpha = (End Price + DPS – Start Price) / Start Price
Alpha = (120 + 5 – 100) / 100 = 25 / 100
 = 0.25

This result of 0.25, or 25%, indicates that the fund has outperformed its benchmark by 25% over the period. This positive alpha suggests that the fund manager has added significant value compared to the benchmark index, reflecting effective management and investment decisions.