Jargon buster: Alpha vs. Beta

Andrew Kemp, head of asset consulting at Liberty Corporate, gives Maya on Money the low-down on Alpha and Beta.

Maya on Money: What do Alpha and Beta mean to an investor?

Kemp: Alpha and Beta are two investment terms which are often bandied around by investment managers when explaining their investment performance. Beta is a measure of how a portfolio of shares is affected by what is called undiversifiable risk, as compared to the market’s reaction as a whole. For example, if some macroeconomic event caused the market as a whole to move up 1% and your portfolio of shares was to move 0,8%, your portfolio would have a beta of 0,8. A beta of less than one implies that the portfolio should be less volatile than the market, whereas a beta greater than one means the portfolio is more volatile.

Alpha, on the other hand, is used in a number of contexts, but generally refers to outperformance of the benchmark, technically on a risk adjusted basis, although often industry players will refer to any outperformance of the benchmark as alpha.

The ability to add alpha consistently is considered to be the mark of good active managers, and the rationale for paying them relatively high fees. On the other hand, if we think of beta as a measure of market movement we can easily get access to cheap investment products which replicate the market’s performance which will give us beta performance of around 1. The point here is that it is relatively cheap and easy to buy the market’s performance (beta), but more expensive to buy performance generated by skill (alpha).

Maya on Money: How is Alpha independent from market returns?

Kemp: Alpha is generated by the skill of the investment manager, as opposed to beta, which is generated by having broad exposure to the market as a whole. Alpha can be generated by highly concentrated equity positions, or investment strategies which effectively strip out the impact of the market and isolate the performance of a specific share or group of shares.

The easiest way of understanding this is to contrast the approach of a manager who has a relatively small number of shares in which he is holding relatively big positions, as opposed to a manager who is holding a large number of shares which gives him broad exposure to the market.

The highly concentrated manager is more likely to deliver a significant amount of alpha than the more diversified manager who will probably have a larger contribution from beta (although this does to a certain extent depend on the composition of the market index – the South African All Share (ALSI)  has a very high concentration in Anglos and Billiton, which complicates this analysis slightly).

Maya on Money: How do you know the difference between alpha and beta products?

Kemp: This is an important question as beta (general market performance) should really be a very cheap commodity because it is possible to buy an inexpensive index tracking fund or exchange-traded fund which will mimic the market’s performance. On the other hand, generating alpha requires skill, which is often expensive. Examples of products which may generate alpha are hedge funds and certain very active long-only funds.

Investors need to be careful that they don’t end up paying active management fees for beta-type performance, which is a danger in many long-only equity products. Many of these products are relatively expensive but produce returns which, after fees, are about the same as, or below those of, the index.

         

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