Tuesday, April 6, 2021

What is Alpha, Beta And Correlation (ABC) of a mutual fund Schemes

Whether you’ve managed your investments well into traditional PPF,NSC,Fixed Deposits or just got a Few Mutual Fund's a couple of years ago, it’s always wise to get back to the basics and refresh yourself on some of the most critical components of successful investing. In particular for Mutual Funds, As per my understanding  there are three metrics you must be mindful of to win at investing in Mutual Funds. Unfortunately even many of the pros forget what I call the ABCs of Mutual Fund investing (at their own peril), so refocus your Mutual Fund investment strategy in this volatile market with these simple yet profound reminders:

(A) Alpha - Investopedia defines Alpha as: “A measure of performance on a risk-adjusted basis. Alpha takes the volatility (price risk) of a mutual fund and compares its risk-adjusted performance to a benchmark index. The excess return of the fund relative to the return of the benchmark index is a fund’s alpha.”
My plain English definition: Alpha tells you if the investment manager is worth what you pay him. Alpha tells you how well a mutual fund or similar investment performs compared to the stated benchmark it’s trying to beat. 
If a funds benchmark is the Nifty index and the index returned 20% while the fund returned 22%, then the fund will have a positive Alpha (obviously positive Alpha is good, negative Alpha is bad). Compare the Alpha over longer time periods in order to understand what value the manager brings to the table versus the index he is trying to beat.

(B) Beta - Investopedia defines Beta as: “A measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole. Beta is used in the capital asset pricing model (CAPM), a model that calculates the expected return of an asset based on its beta and expected market returns. Beta is calculated using regression analysis, and you can think of beta as the tendency of a security’s returns to respond to swings in the market.
My plain English definition: Beta is an expression of how volatile an investment is compared to the overall market. A beta of 1 indicates that the investment will move with the market. A beta of less than 1 means that the investment will be less volatile than the market. For example, if a Fund’s beta is 1.3, then theoretically it’s 30% more volatile than the broad market.

(C) Correlation - Investopedia defines correlation as: “…what is known as the correlation coefficient, which ranges between -1 and +1. Perfect positive correlation (a correlation co-efficient of +1) implies that as one security moves, either up or down, the other security will move in lockstep, in the same direction. Alternatively, perfect negative correlation means that if one security moves in either direction the security that is perfectly negatively correlated will move in the opposite direction. If the correlation is 0, the movements of the securities are said to have no correlation; they are completely random.”
My plain English definition: Correlation simply describes how two things are similar or dissimilar to each other. Specifically, how two investments move in relation to each other, how tightly they are linked or opposed. Correlation between historically dissimilar investments (think stocks and bonds) is never static, it’s not uncommon for the correlation of investments to change, especially during volatile or crashing markets. 

In fact, seemingly the only thing that goes up in a down market is in fact correlation. I use correlation measurements in advanced portfolio management to better manage risk. 

To me, higher correlation theoretically means higher risk to the bottom line. The higher the correlation of your investments the higher of the “doubling-down” effect you get, in other word's you have a greater opportunity for gains or financial ruin. One particular ripe investment class for high correlation are mutual funds because both bond funds AND Equity funds trade on the market, thu's your bond funds become more correlated with Equity funds during volatile markets.

Many investors tend to focus exclusively on investment return, with little concern for investment risk. Risk measures we have just discussed can provide some balance to the risk-return equation. 

As useful as these measurements are, keep in mind that when considering a stock, bond or mutual fund investment, volatility risk is just one of the factors you should be considering that can affect the quality of an investment.



Ritesh.Sheth CWM®
CHARTERED WEALTH MANAGER

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Disclaimer:This blog is addressed to and intended for the investors of Ritesh Sheth & Tejas Consultancy only. You are advised to contact Ritesh Sheth & Tejas Consultancy to clarify any issue that you may have with regards to any information contained in this emailer. The views are personal. Ritesh Sheth & Family or Tejas Consultancy does not guarantee the accuracy, adequacy or completeness of any information in this blog and is not responsible for any errors or omissions or for results obtained from the use of such information. Investopedia definitions are used for educational purpose. Ritesh Sheth & Family or Tejas Consultancy does not have any liability to any person on account of the use of information provided herein and the said information is provided on a best effort basis only for educating investor. In case of investments in any of our schemes, please read the offer documents carefully before investing. 

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