August 14, 2008, 6:00 am

Beta and Alpha

by: The Financial Blogger    Category: Investment, Market and Risk
email this postEmail This Post Print This PostPrint This Post Post a CommentPost a Comment


In the other day’s column, there was a very interesting comment made by Richard about two additional things you would be looking into when investing in a fund. I thought they were good points although I wanted to make a few precisions so here you go, an entire post about the two.

 


So what are beta and alpha? They are two measures made on historical returns of a specific fund (beta also applies very well to individual securities). First off, beta. A beta is the correlation between an asset and an index. When talking about a beta, it is important to know what it compares to. Usually, when giving out a beta, it will be against a broad index such as the TSE60 or S&P500. Richard was saying that you were looking for a low beta. Well, to a degree yes. But not necessarily. To give you a more concrete idea of what beta is, let’s pretend you are investing in a fund, here are the expected returns given a 10% market performance:

Beta Performance

Beta -1 -10%

Beta 0 0%

Beta 1 10%

Beta 2 20%

So generally you would be looking to diversify your portfolio and in that case, as Richard said, you would want a low beta, that will help you gain good returns no matter what the market does. However, you could very well wish to add more risk and go for a fund that has a high return. So I would not agree entirely with Richard just because it depends on circumstances, but in general yes investors are looking for a low beta.

A side note would be to note that generally beta is only related to equity indexes and thus you will not see how diversified your portfolio will be with other asset classes such as bonds and commodities.

As for Alpha, no doubt here, the more the better. Again, this is a historical mesure. Generally, it is calculated by taking funds that have a similar level of risk. Given that, any return above that return is considered alpha and thus certainly something any investor would be looking for. However, it’s not the only criteria obviously as numerous research papers have showed how past performance is not very correlated with future returns for managers (apart from the very talented ones which are a lot more rare than you could imagine).

All for now, thanks for the comment Richard

Similar Posts:

You Want More? Sign-up! ->
TFB VIP Newsletter


If you liked this articles, you might want to sign for my FULL RSS FEEDS. If you prefer to receive the posts in your email, subscribe CLICK HERE


Comments

Not a problem. I’m honored.

The key here is the fact that pure alpha is theoretically uncorrelated with beta. And that makes it a potentially very valuable addition to an investor’s portfolio. Moreover, the separation of beta and alpha make it much easier for an investor to define and control his or her exposure to risk. For example, assume that your target asset allocation leads to a portfolio with an expected annual standard deviation of returns (volatility) of 15%, based on beta risk alone. You could then say, “I’m willing to take on a further 1% in risk in pursuit of additional alpha returns”. This type of calculation is close to impossible to make in a world of long-only actively managed funds that combine alpha and beta exposure. It is only when beta and alpha investing are separated that it becomes theoretically possible.

Sam
Fix My Personal Finance
http://fixmypersonalfinance.com

[...] Just when you though that maybe ETF’s were perhaps starting to lose a bit of their “in” factor, a new class of ETF’s has been unveiled that could restart the whole trend. In Canada, “Betapro” ETF’s are high volume ETF’s that are usually leveraged and track known indexes such as commodities or stock indexes. Now, the company behind those is launching “alphapro”, a class of ETF’s that would track the trades done by “guru’s” of finance. Of course, the idea behind it is to be able to generate alpha. [...]