You may have heard investment professionals refer to alpha and beta. But what exactly are they talking about?

 

The financial industry likes to make investing complicated. It prefers to use jargon, and even ancient Greek letters like alpha and beta, instead of plain English. 

Here at rockwealth, we strongly believe that successful, evidence-based investing is far more simple than many financial advisers make it seem. We see it as part of our role to demystify investing and to explain important concepts in language that our clients can understand.

So what exactly is meant by alpha and beta? Essentially, alpha and beta refer to two fundamental concepts used to assess investment performance and risk. 

To understand alpha and beta properly, you first need to grasp what we mean by an index. An index is like a basket of financial assets, typically shares or bonds. 

The composition of an index is usually based on specific criteria, such as market capitalisation (or the number of shares in circulation), industry or geographical location. For example, the FTSE 100 Index includes 100 of the largest companies listed on the London Stock Exchange.

The other term you need to understand is benchmarking. Indexes are often used as benchmarks to measure investment performance. For example, a fund that invests in large US companies might use the S&P 500 as a benchmark. 

The returns produced by each index are typically measured over periods of one, three, five and ten years. Some professional investors, or fund managers, will outperform their benchmark index and some will underperform it.

 

Alpha

Alpha refers to the returns a fund produces compared to the returns delivered by the benchmark index. If a fund’s alpha is positive, it means the fund has performed better than the benchmark, after adjusting for the amount of risk the fund manager has taken. Conversely, a negative alpha indicates that the fund has underperformed the benchmark index. 

Essentially, then, alpha is a measure of a fund’s risk-adjusted performance and is often considered to represent the value added or subtracted by a particular fund manager.

 

Beta 

What, then, is beta? Well, beta measures the volatility of a fund relative to the overall market. The market, typically represented by a benchmark index like the FTSE 250 or S&P 500, is assigned a beta of 1.0. An investment with a beta greater than 1 is more volatile than the market, implying that it might offer higher returns in a bull market but may be riskier. An investment with a beta less than 1 is less volatile and may not rise as much in a bull market but could be less risky during downturns. 

Beta is primarily used for understanding and managing what’s called the systematic risk of a fund or stock. Systematic risk refers to the risk inherent in the entire market. It’s caused by factors, such as economic recessions, political turmoil, changes in interest rates, natural disasters, or global events. 

There is nothing investors can do about systematic risk. It cannot be eliminated through diversification, as it affects all assets to some degree or other.

 

Implications for investors

So what does all this mean in practice for you as an investor? 

In a nutshell it means you have a choice. On the one hand you can try to access alpha — in other words, outperform the market — by using an active fund manager fund who tries to buy and sell the right stocks at the right time. On the other hand, you can simply settle for beta — in other words, the overall market return.

Presented with that choice, people are naturally inclined to choose the former option. It’s human nature to want to outperform the market. After all, most people would like to receive the highest possible return.

But there’s a problem: accessing alpha is extremely challenging. Why? Because stock markets are actually very efficient. Current prices reflect all the very latest information, and so it’s very hard for any fund manager to say whether a particular share is either undervalued or overvalued at any one time.

The evidence from organisations like Morningstar and S&P Dow Jones Indices shows us, time and again, that most active managers underperform most of the time. Funds often outperform in relatively short bursts. In the long run, though, only a tiny proportion of them succeed in beating the benchmark on a risk-adjusted basis once their fees and charges are factored in.

Of course, we can all see which funds have outperformed in the past: those are the funds we tend to read about in the weekend papers. But no one can tell you which funds will beat the market in the future. Sure, you might be able to identify a future star manager in advance, but the odds of doing so are heavily stacked against you.

 

A better alternative

Thankfully, there is a much better alternative. Passively managed index funds track entire markets. In other words, they don’t even try to outperform; they simply aim to replicate the index and capture the market return, or beta.

The big advantage that index funds have over active funds is that they are almost invariably very much cheaper, and costs make a huge difference over time. After costs, the vast majority of active funds will underperform a comparable index tracker over longer periods.

To put it another way, by trying to beat the market, most investors end up being beaten by the market. Indeed, over several decades of investing, the difference in net returns achieved by active and passive investors can be very substantial.

 

Alpha and beta: the choice is yours

So what are you going to do? Are you going to chase after alpha by trying to pick a future long-term outperformer, even though, statistically, you are highly unlikely to do so? Or are you going to settle for beta instead by investing in low-cost passive funds and simply capture the returns of the whole market?

Whichever option to choose, you’re taking a risk. Again, there’s no escaping systematic risk: active and passive investors are both affected. But by investing passively you avoid the risk — indeed the likelihood — of underperforming the market quite substantially in the long run.

When it comes to alpha and beta, we strongly advise our clients to accept the evidence that chasing alpha is a loser’s game. Capturing beta might sound rather less exciting, but it is, unquestionably, a far more rational option.

 

FIND OUT MORE

Want to find out more about rockwealth Norwich and how we can help you to achieve your goals? Then give us a call or send us a message. We would love to hear from you.

 

© rockwealth MMXXIII

 

Financial Planner in Norwich

rockwealth Norwich is an evidence-based and fee-only Financial Planning firm situated in the City of Norwich, Norfolk.

About: rockwealth Norwich IFA, is based in the centre of Norwich. As an independent financial planning adviser, we can help with many financial services, from independent financial advice, pension and retirement advice, investment advice and inheritance tax planning.

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