Ratios which Investors should consider while choosing Mutual Fund Schemes by Mirae Asset Knowledge Academy Investing by considering only historical returns in a mutual fund scheme is risky. Investors need to evaluate the risk involved in mutual fund schemes before investing. There are no of ratios which mutual fund investors should consider before making their investments. In this article we will cover Jensen’s Alpha ratio.
Definition: The simplest definition is the excess returns of the fund over the benchmark. Alpha is performance ratio to measure risk-adjusted performance of a portfolio, intended to help investors determine the risk-reward profile of a mutual fund. Alpha measures the difference between a fund's actual returns and its expected performance, given its level of risk. A fund's alpha is often considered to represent the value that a portfolio manager adds to or subtracts from a fund's return above and beyond a relevant index's risk/reward profile. Jensen's alpha was first used as a measure in the evaluation of mutual fund managers by Michael Jensen in 1968.
Computation: Alpha = {(Fund return-Risk free return) – (Funds beta) *(Benchmark return- risk free return)}. Example: Fund return Risk free return Benchmark return Beta of Fund
10% 8% 5% 0.8
By computing with above formula we will get alpha as 4.4 for this fund
Significance The Alpha as represented by percentage indicates under performance or Outperformance of a portfolio.
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A positive alpha means the fund has outperformed its benchmark index. Correspondingly, a negative alpha would indicate an underperformance. As a fund's return and its risk both contribute to its alpha, two funds with the same returns could have different alphas.
Investors are often advised to pick funds with high Jensen Alpha ratios.