Risk-Adjusted Returns in Mutual Funds: Understanding Alpha, Beta, and Sharpe

Risk-adjusted returns measure investment performance relative to the risk involved. Instead of focusing only on how much a fund earned, they help explain how smoothly or unevenly those returns were achieved.

Two funds may show similar average returns, but one may have experienced larger swings in value. Risk-adjusted metrics provide a way to compare such funds on a more comparable basis by factoring in volatility and market sensitivity.

In mutual fund analysis, the most commonly used risk-adjusted metrics are:

• Beta

• Alpha

• Sharpe Ratio

Each looks at risk from a different angle.

Risk-adjusted measures help investors:

• Understand return consistency over time

• Compare funds with different volatility levels

• Assess how closely returns followed market movements

• Evaluate performance across different market phases

• Align fund behaviour with personal risk comfort and time horizon

These metrics are most useful when comparing funds within the same category.

Beta measures how sensitive a fund is to movements in the broader market benchmark.

• A beta close to 1 indicates the fund tends to move broadly in line with the market

• A beta above 1 indicates higher volatility than the market

• A beta below 1 indicates lower volatility than the market

For example, if a fund rises more than the market during upward phases and falls more during corrections, it is likely to have a higher beta. Conversely, a fund that moves less than the market in both directions will have a lower beta.

Beta does not measure performance quality. It only describes how a fund reacts to market movements.

Alpha measures how much extra return a mutual fund generated compared to its benchmark index. It answers a simple question: Did the fund deliver more or less than what the benchmark delivered for the same period?

If the benchmark returned 15% and the fund delivered 20%, the alpha is +5%. This indicates the fund added value beyond what the benchmark provided.

If the fund delivered only 8% when the benchmark delivered 15%, the alpha is -7%, signaling underperformance.

In simpler terms, alpha shows whether the fund manager’s decisions helped the fund do better or worse than the benchmark.

How to read alpha:

Positive alpha means the fund outperformed its benchmark

Negative alpha means the fund underperformed its benchmark

Zero alpha means performance matched the benchmark

Alpha should always be assessed over longer periods and only within the same category. Short term alpha often fluctuates due to market conditions that may not reflect skill or long term consistency.

The Sharpe Ratio compares excess returns to the total volatility experienced by the fund.

A higher Sharpe Ratio indicates that the fund delivered more returns for each unit of risk taken. A lower Sharpe Ratio suggests returns were achieved with relatively higher volatility.

Sharpe Ratios are most meaningful when:

• Compared across funds in the same category

• Evaluated over longer time frames

• Viewed alongside other risk metrics

Rather than ranking funds, Sharpe helps describe how efficiently returns were generated.

Alpha, beta, and Sharpe Ratio each highlight a different aspect of risk and return.

• Beta explains how closely a fund moves with the market

• Alpha reflects how much return the fund delivered above or below its benchmark, after accounting for market movement.

• Sharpe shows how much volatility accompanied the returns

When reviewed together, these metrics provide a more rounded picture than any single measure on its own.

Risk-adjusted metrics are most useful when:

• Comparing funds with similar objectives

• Evaluating consistency across market cycles

• Understanding how a fund behaves during both rising and falling markets

They are less effective when used in isolation or across very different fund categories.

No single metric defines suitability. These measures help explain behaviour, not predict future outcomes.

In this example, Fund A achieved higher returns but experienced greater volatility. Fund B delivered returns with lower fluctuations, resulting in a higher Sharpe Ratio. The comparison highlights differences in return efficiency rather than indicating superiority.

A higher Sharpe Ratio does not automatically make a fund better for every investor. Risk preferences and time horizons differ.

A low beta does not mean a fund is suitable for all goals. While it reduces volatility, it may also limit participation during strong market phases.

Negative alpha over short periods does not necessarily indicate a flawed strategy. Market cycles and style differences can influence outcomes temporarily.