While evaluating the performance of a fund, analysts look at several factors such as the asset size, expense ratio, past returns and company or sector allocation patterns among others. Out of these, the past performance of a fund is widely quoted in fact sheets, research reports and advertisements that solicit mutual fund investments. Though the past performance of a fund is important, it completely ignores the risks taken by the fund.
Mutual funds face two types of risks while investing in stocks: i) Company specific and ii) market specific. A fund aims to eliminate company-specific risks by diversifying their holdings. However, market risk (also known as systematic risk) cannot be eradicated. A well-diversified mutual fund then is prone to market risks only. The returns that a fund generates must be in accordance with the risks it is exposed to. Such risk-adjusted returns are called expected returns.
For making risk-return analysis, analysts use a statistical tool known as alpha (also known as Jensen’s alpha after American economist Michael Jensen who developed it). This measures a fund’s returns relative to its expected returns. A fund that consistently generates higher return relative to its expected return is an outperformer. Alpha is also used by analysts to evaluate the performance of the fund manager. A positive value of alpha means that the fund manager’s stock picking and market timing skills.
For a retail investor the alpha value is important because it measures the excess returns a fund has generated in relation to the returns generated by its benchmark. Alpha values are readily available on websites like valuereseachonline.com and myplexus.com.
Do such positive alpha funds really perform better than the negative alpha funds? We decided to test this by studying the performance of equity-diversified funds. The funds were filtered by looking at funds that are more than five years old and only growth-option funds were selected. After applying these filters we zeroed-in on 116 funds. Out of these, 69 were positive alpha, 24 were negative and 23 have alpha value of zero. We ignored funds with zero alpha values.
We then analysed the performance of positive and negative alpha funds over a period of one year, three years and five years. In these three time periods 56% of the positive alpha funds consistently outperformed their benchmarks. On the other hand, 58% of the negative alpha funds consistently underperformed their benchmarks. This shows that the funds that generate excess returns have the ability to outperform in the medium term and the long term.
However, alpha should be used cautiously while evaluating funds that are not fully diversified. This is because alpha only considers market risk and ignores company-specific risks. Therefore, it gives a distorted picture of the risk-adjusted returns in case of less-diversified funds because such funds are also prone to the company-specific risks.
Mutual funds face two types of risks while investing in stocks: i) Company specific and ii) market specific. A fund aims to eliminate company-specific risks by diversifying their holdings. However, market risk (also known as systematic risk) cannot be eradicated. A well-diversified mutual fund then is prone to market risks only. The returns that a fund generates must be in accordance with the risks it is exposed to. Such risk-adjusted returns are called expected returns.
For making risk-return analysis, analysts use a statistical tool known as alpha (also known as Jensen’s alpha after American economist Michael Jensen who developed it). This measures a fund’s returns relative to its expected returns. A fund that consistently generates higher return relative to its expected return is an outperformer. Alpha is also used by analysts to evaluate the performance of the fund manager. A positive value of alpha means that the fund manager’s stock picking and market timing skills.
For a retail investor the alpha value is important because it measures the excess returns a fund has generated in relation to the returns generated by its benchmark. Alpha values are readily available on websites like valuereseachonline.com and myplexus.com.
Do such positive alpha funds really perform better than the negative alpha funds? We decided to test this by studying the performance of equity-diversified funds. The funds were filtered by looking at funds that are more than five years old and only growth-option funds were selected. After applying these filters we zeroed-in on 116 funds. Out of these, 69 were positive alpha, 24 were negative and 23 have alpha value of zero. We ignored funds with zero alpha values.
We then analysed the performance of positive and negative alpha funds over a period of one year, three years and five years. In these three time periods 56% of the positive alpha funds consistently outperformed their benchmarks. On the other hand, 58% of the negative alpha funds consistently underperformed their benchmarks. This shows that the funds that generate excess returns have the ability to outperform in the medium term and the long term.
However, alpha should be used cautiously while evaluating funds that are not fully diversified. This is because alpha only considers market risk and ignores company-specific risks. Therefore, it gives a distorted picture of the risk-adjusted returns in case of less-diversified funds because such funds are also prone to the company-specific risks.
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