How To Use ‘Alpha’ To Make Equity Investment Decisions

By | July 24, 2016

How To Use 'Alpha' To Make Equity Investment Decisions

Alpha and beta will sound like Greek to lay investors. In mathematics, these letters are used as variables and have a simple connotation. But in the world of finance, it is an esoteric concept even for seasoned professionals. The calculation of alpha and beta is a science in itself.

Investors would have heard about these two terms being used by analysts on TV or in newspapers. In this article, we will discuss and decode their meaning. We’ll also talk about how we can use them to make better investment decisions.

The measurement of alpha requires beta to be measured first. So let us first discuss beta.

 Beta: The Measure of Market Risk

There are two major risks inherent to every stock listed in the market. They are market risk (or systematic risk) and company risk (or non-systematic risk). Market risk measures the impact on a stock price arising out of overall market conditions. The overall market condition is affected by macroeconomic factors such as GDP growth, changes in global forces, war, severe changes in overseas markets, monsoon (in Indian case) and its absence, regulatory policies, and other factors where companies have no control.

The degree of impact is measured by beta. Beta can be positive or negative. Positive beta shows positive correlation while negative beta implies the opposite. Positive beta means when the market goes up, the stock goes up, and vice versa.

Beta is a numeric value. Suppose a stock has a beta of 1.2. This means if market goes up by 6% in a year, a beta value of 1.2 will drive the price of the stock up by 7.2% (1.2 times 6%) over the same year. A beta of -1.2 (negative 1.2) means the stock will go down by 7.2%.

Obviously, a beta of 1 means identical movement with the market. In the above example, a market movement of 6% will result in the stock price changing by 6%. Beta is calculated by using the correlation coefficient of market performance with that of the stock.

 Alpha: A Measure of Performance

Alpha, on the other hand, measures the excess over the expected return from the stock or fund.

The expected return is calculated using various models. One of the most used is CAPM (Capital Asset Pricing Model). The CAPM for a stock or fund is calculated as Re =Rf + (Rm – Rf)*𝛃

Where Re =expected return of stock or fund

Rm =market return

Rf =risk-free rate

𝛃=beta of the stock or fund

Let’s understand this with an example. Let a Mutual Fund comprise of 20 large cap firms. The beta of the fund is 1.2, calculated by factoring proportion and individual betas of the underlying firms. Let the risk-free rate be 8%, which is nothing but the return on the Government’s long-term bond. Let the market return be 14%. Market return is the compounded annual return of the Sensex or Nifty or such benchmark indices over the previous 20-30 years depending on the availability of data.

The expected return would be 15.2%. If the Mutual Fund gives a return of 18% annually, the alpha would be 2.8%, i.e. the excess of 18% over the expected return of 15.2%.

 How To Use Alpha & Beta

Fortunately, you don’t have to calculate all these parameters before deciding on which Mutual Funds to invest in. In most of the funds’ data, alpha and beta along with other important numbers would be mentioned.

Hence, when you look for investment, you should compare the alpha of various funds in the same category and evaluate the performance.

For example, a fund with a higher alpha would be more preferable to a fund with lower alpha.

 Other Ways To Calculate Alpha

Some fund managers may calculate alpha by determining excess return with respect to a relevant benchmark index. For example, a Mutual Fund investing in large-cap funds may use the Sensex as the benchmark. If the Mutual Fund’s beta is 1.2 and the Sensex returns in a given year are 10%, the fund’s alpha may be calculated by looking at excess returns over 12% (10% times 1.2). Hence, if the return of Mutual Fund over the same period is 15%, its alpha will be 3%.

Quite a bit to take, isn’t it? That should make the concept of ‘alpha’ and ‘beta’ clear!

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