Understanding Mutual Fund Alpha and Risk: A Comprehensive Guide

Evaluating mutual fund risk is an important part of the mutual fund investment process. Before deciding on a mutual fund, you will want to determine how risky of an investment it is. Alpha is one source of financial comparison that you can use to determine the risk of a mutual fund. Here are the basics of Alpha and how it impacts mutual funds.

Alpha

As part of modern portfolio theory, there are five technical risk ratios that are utilized to evaluate investments. Alpha is one of the five and helps to determine the risk associated with investment. With Alpha, you compare the risk-adjusted performance of a mutual fund, and compare it to its benchmark. This helps you to determine exactly how much is added or subtracted to the value of a mutual fund, depending on the fund manager.

The capital asset pricing model, or CAPM, is a common statistical method to determine how much of return you can expect from investment. If the CAPM tells you that an investment will earn 5% and then in reality it actually earns 10%, the Alpha would be the difference between the two, 5%. This tells you that the investment decisions of the manager were worth 5% to the portfolio.