Alpha versus Beta

Firstly, for performance evaluation, it is imperative to have the right benchmark for comparison. For instance, for large cap funds, you should compare them versus the Nifty or Sensex while for multi-cap funds, a comparison versus BSE 200 may be more appropriate.

Having selected the right benchmark, the question arises as to which measure to be used for evaluating the performance. This is dependent on the views and the requirements of the investor.

If an investor is looking to cash in on a bullish momentum that he expects in the market, ascertaining the beta of various short listed equity funds would help him choose the right vehicle to participate in the expected market action. Here, more than stock picking abilities of a fund manager - whose results may show up over time - the investor is really looking for a portfolio filled with "high momentum" stocks, which can outperform the market in the near term in bullish phases. A fund with a high beta would be well positioned to do the job for him. Many of the "Opportunities" funds in the market are constructed with beta greater than 1.

If on the other hand, the investor believes that mispricing persists in the markets and that markets are not very efficient, he would look for an actively managed fund which can find these "mispriced" opportunities and make more money over time than the market. This is the "alpha" that the fund manager seeks to achieve - a return in excess of market returns - which is primarily attributable to his superior stock picking skills.

Actively managed funds usually cost more than passive funds. The expense ratio of an index fund (a passive fund) is usually 1% while most actively managed funds cost upto 2% p.a. The fund manager's alpha should be sizeably higher than this incremental cost, for it to be worthwhile for the investor to take the incremental risk and bear the incremental cost.

Having said that, alpha is a true measure of stock picking ability of a fund manager. There are two ways of evaluating the performance of a fund manager who has delivered alpha returns on the fund. One is to simply look at the amount of alpha generated and measure the outperformance of the fund over its benchmark. Second is to measure the incremental return produced for a fund at a given beta. In the illustration discussed earlier, beta was assumed to be 1.1. However if we assume beta to be 1.4, alpha is reduced to 5.2 %.This will lead one to analyze the fund managers stock picking ability and the incremental proportion of alpha returns delivered by him that are over and above the momentum based returns.