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Let us Talk Greek - Understanding Alpha and Beta
April 20, 2009

We explain why alpha and beta are important concepts in understanding and measuring an investment's performance.


Author : iFAST Research Team



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The Greek language is often thought to be very difficult, which is why we hear the expression, “it’s all Greek to me” when people do not understand something clearly. However, an interesting fact not known to some of us is that the Greek alphabet is the oldest alphabetic script in use today and its letters are widely used in mathematics and in finance.

In this article, we will be talking about two of the more commonly used Greek alphabets in finance, particularly in portfolio management – alpha and beta, which also happen to be the first two letters of the Greek alphabet. The symbol for alpha is α, while the symbol for beta is β.  

Is it important to know what they are? In short, yes. They are important especially if you have an investment portfolio or if you are managing one actively for someone else. When we refer to an investment portfolio, it naturally assumes a certain amount of diversification, meaning that the investor holds different types of asset classes, like bonds and equities, or simply a range of different types of equities in his portfolio.  

Simply put, a portfolio that is 100% invested into one particular security cannot be considered to be diversified, while investing into just two securities already achieves a certain amount of diversification. This is nothing new to most of us, because we intuitively understand that diversifying reduces risk – if one investment completely blows up in your face, at least you would still have the other portion of your money in something else that is unlikely to melt down completely at exactly the same time as the other investment.  

As to how diversified a portfolio should be, that will be a topic for another article in the future. Yet it begs the question: is it true that all risk can be diversified away?  

This is where beta comes in. (β). Before we get to that, we have to first understand that two types of risks exist for the investor – systematic and unsystematic risk. It is important to note that we can easily reduce unsystematic risk through diversification.

As the name implies, unsystematic risk is an inherent risk in investing. Putting aside all these financial jargon for a while, we can consider the analogy of a long-distance athlete (an investor). The athlete (investor) learns to train (invest) on the treadmill in the gym every single day, and only on that one particular machine (an undiversified portfolio). If the treadmill breaks down suddenly (investment makes massive losses), his training will suffer badly as he does not know how to train on anything else. The breakdown of the treadmill was an inherent risk when using the machine that the athlete could not have foreseen. This scenario is exactly the unsystematic risk that finance theory refers to!  

However, if the athlete knows how to use the rowing machine and/or the cycling machine, he would in effect have achieved diversification away from using just the treadmill machine, and reduced his unsystematic risk (or the equivalent of it in the athlete’s terms).  

Now that we understand unsystematic risk, the concept of systematic risk should be clearer by now. Systematic risk cannot be reduced, even if one is able to achieve perfect diversification. The athlete may know how to use every single machine in the gym, but that would not help him if the gym was suddenly closed for renovation or it suddenly burned down in a freak accident.

Now that we have gotten that out of the way, we can finally start talking Greek.

Beta  

We have established that investing always involves certain amounts of risk, and that a certain type of risk known as systematic risk exists that cannot be reduced through diversification. It is also called market risk, because even if you were to buy the entire market and in the process achieving perfect diversification, systematic risk would still exist.

Now, what does β measure? It measures the volatility of a security or a portfolio in relation to the market. When we refer to the market, we usually refer to the returns of a particular index, especially a broad-based one like the S&P 500. By definition, the market has an underlying beta of 1.0. The table below shows some examples of how we can interpret various betas.

Table 1: Interpreting Beta for Various Assets / Portfolio

Asset / Portfolio  

β

Interpretation For The Asset / Portfolio

W  

2.0

Twice as volatile as the market.

X

0.5

Half as volatile as the market .

Y  

0

Independent of market volatility.

 Z

-0.4

Inverse correlation with market movement. The security delivers positive returns in a falling market and negative returns in a rising market.  

Source: iFAST Compilations

You will notice that in Table 1, beta is a good measure of the risk (volatility) of a particular security/portfolio relative to the market. In other words, it measures the effect of systematic risk on a particular security. A higher beta indicates that the asset is more risky than the market and is thus expected to deliver higher returns than the market as well.  

Beta is thus an extremely useful measure for investors to understand how to create their own individual portfolios in accordance with their ability to take risk. Does this mean that one should fill their portfolios with securities that have higher betas than the overall market so that one can easily beat the market – supposedly the holy grail of many portfolio managers?  We will look at that later when discussing alpha (α).

However, useful as beta is in giving us an idea on risk, we should be aware that it does have its own limitations. As previously mentioned, beta measures risk of a particular security relative to the market – but no index exists where betas of all classes of assets can be measured against. Thus, we can only use a broad-based index like the MSCI World or the S&P 500 which are imperfect proxies for market risk.  

Secondly, beta is calculated based on historical data. This means that it only gives us an idea of historical risk of the security relative to the market and cannot predict any change in the risk of the asset in the future.  

Nonetheless, beta is an extremely useful tool for calculating the risk of holding a particular security within a portfolio relative to the market risk and it is widely used in calculating expected returns in financial models like the CAPM (Capital Asset Pricing Model).

Alpha

Alpha is good, more alpha is better. The concept of alpha and the quest to produce it is all pervading within the investment world by active portfolio managers. What exactly is this thing called alpha that makes it so sought after? To understand this better, we have to understand some ideas about financial markets, particularly the Efficient Market Hypothesis (EMH).  

In a nutshell, the EMH puts forth the argument that financial markets are “efficient” in the sense that all public information on traded assets is already reflected in the price of the asset. In other words, the collective expectation of the market about prices, taking into account all available information, makes it hard to generate abnormal profits in the long run.  

This does not mean that good profits cannot be generated in the short run, as markets may go through short windows of irrationality or new information may be filtered out into the market inefficiently, allowing a small period by which privileged recipients of new information may then be able to act on to generate profits. Yet most proponents of the EMH believe that it is extremely difficult to consistently beat the market in the long run, owing to this efficiency in the market.  

Is it true that the market cannot be beaten in the long run? Certain individuals have certainly done it like Warren Buffett, known to many as an investment genius but also thought as a statistical anomaly by many supporters of the EMH, as he has managed to outperform the S&P 500 for over 40 years during his time as chairman of Berkshire Hathaway, his investment holding company!  

By now readers should have an inkling of what alpha is. Alpha really just refers to the additional returns over the market return. If you hear of a portfolio manager being able to “generate alpha”, it is tantamount to saying that he has delivered more returns than the market – he beat the market! In the world of active fund management, the ability to generate alpha is extremely lauded by the industry, showing just how important this standard of performance has become in recent times.

Conclusion

This article ties up a few simple financial concepts along with the understanding of alpha and beta. How do alpha and beta relate to each other and how are we able to use them to judge the performance of a portfolio manager?  

Investors can easily conclude for themselves if a portfolio manager has performed well - bearing in mind that high returns always come with higher risks. The most ideal scenario, assuming that investors are risk-adverse, would be the one where investors are able to get the highest possible returns for the lowest possible amount of risk.

A high alpha (high excess returns) in isolation may not be looked upon as favorably if the beta (risk relative to the market) of his portfolio was extremely high. As proponents of investor education, we hope that introducing these concepts will allow investors to understand the concepts of alpha and beta, and if possible, pave the way for making better investment decisions going forward. Hopefully, you have had a good time learning Greek!


iFAST and/or its content and research team’s licensed representatives may own or have positions in the mutual funds of any of the Asset Management Company mentioned or referred to in the article, and may from time to time add or dispose of, or be materially interested in any such. This article is not to be construed as an offer or solicitation for the subscription, purchase or sale of any mutual fund. No investment decision should be taken without first viewing a mutual fund's offer document/scheme additional information/scheme information document. Any advice herein is made on a general basis and does not take into account the specific investment objectives of the specific person or group of persons. Investors should seek for professional investment, tax, and legal advice before making an investment or any other decision. Past performance and any forecast is not necessarily indicative of the future or likely performance of the mutual fund. The value of mutual funds and the income from them may fall as well as rise. Opinions expressed herein are subject to change without notice. Please read our disclaimer in the website.


 


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