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B. Venkatesh

THE article on mutual funds in `Insight' discusses portfolio alpha. What is alpha? It is the risk-adjusted returns that a portfolio manager generates in excess of the risk-adjusted returns expected by the Capital Asset Pricing Model (CAPM).

The CAPM assumes that a portfolio is well diversified. So, investors are rewarded only for the systematic risk. This is because in a diversified portfolio, each stock's non-systematic risk will cancel out or be insignificant.

But what is systematic and non-systematic risk? Suppose the market trades in only one power and one banking company stock. The non-systematic risk from holding the stock of the power company may be, say, deregulation of the power sector and increase in coal prices. For the banking company, the risk may be the changes in the banking regulations and interest rates.

Now, a diversified portfolio assumes that the non-systematic risk of the power company will cancel out that of the banking company. The investor will, thus, be rewarded only for the systematic risk. This is the risk arising from economic variables, and is captured by the portfolio beta.

Suppose the index return is 10 per cent, the portfolio beta is 1.5, and the actual return is 25 per cent. According to the CAPM, the portfolio should be expected to return 15 per cent (1.5 times 10 per cent). This is because the portfolio is 1.5 times riskier than the market. If the risk-free rate is 5 per cent, the risk-adjusted CAPM return should be 10 per cent.

Now, the actual risk-adjusted return is 20 per cent (actual return less risk-free rate). This means that the portfolio manager demonstrated superior stock picking or market timing skills. The difference between the risk-adjusted CAPM return and the actual risk-adjusted return is the alpha. In the above example, it is 5 per cent.

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