Alpha and Beta
Alpha and beta are two concepts deemed so highbrow that they are deserving of a Greek letter apiece.
With disregard for common order, we begin with beta. This attempts to measure the historic sensitivity of an investment relative to a benchmark or index. In the equity world this is the amount that a given share (or portfolio) rises or falls relative to the wider market. Beta is terribly simple and there are only two things about you need to know: first, is it positive or negative? This tells us if the share typically moves the same way as the market (negative beta is rare outside of hedge-world). Second, is it higher or lower than one? This tells us if the moves have been more or less than the benchmark.
As Brucie used to say, that’s all there is to it.
A couple of examples: KAZ Minerals – the Kyrgyzstani mining company – has a high beta of 2.2: this is a stock with above-average sensitivity to the global economy. In contrast, Imperial Tobacco Group has a relatively low beta of 0.5 – the world’s smokers do not tend to vary their inhales much based on the economy, and so Imperial Tobacco shares tends to be less sensitive to general market conditions.
Alpha, on the other hand, attempts to be clever. It measures the return that a portfolio has generated in excess of what would have been expected given its beta. A portfolio with a beta of one should produce a return equal to the market; any miraculous outperformance is deemed to be alpha. For example, the Lindsell Train UK Equity Fund has a beta of 0.9, so should have returned 90% of the return of the market. Instead, it outperformed the market by around 9% over twelve months (as at March 2015; source: Financial Express). That is what we all seek: better performance for less risk.
Alpha and beta break-down the performance of a portfolio into two parts: the return received in compensation from taking market risk (beta), plus the excess return generated over and above that (alpha). Alpha is thus a particularly pertinent concept for active investing. An active manager’s charges are justified on his ability to produce alpha. Cheap passive investing with an index tracker will always have near-zero alpha, since the fund and the market are one and the same. (In fact, the tracker’s “alpha” will be slightly negative since fees mean the tracker will underperform the index.)
Predictably, we do raise some criticisms. The values for alpha and beta are determined by the market or benchmark against which you are measuring the fund. Much as the cassowary will score nul points when judged on its ability to fly, we do protest that many investment benchmarks are really rather poor yardsticks. Especially the terribly flawed concept of market capitalization weighted indices, which feature the unfortunate characteristics of overweighting the expensive and underweighting the cheap. Picking a relevant benchmark is crucial.
The nature of this benchmark can also change without the share or fund altering at all; thus olde-worlde blue chips looked terribly risky in the dotcom era as judged by alpha-beta as the shares all went down when the dotcom dominated market raced upwards. In the real world the businesses were just as profitable and the shares proved to be spectacularly cheap.