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Aplha Beta

Beta is a measure of the volatility of a security or portfolio compared to the market. It represents the tendency of a security's returns to respond to swings in the overall market. Alpha is a measure of performance on a risk-adjusted basis that represents the value added or subtracted by an investment manager compared to a benchmark index after adjusting for risk. Alpha can also refer to the abnormal rate of return of a security or portfolio above what is predicted by the capital asset pricing model based on its risk profile. While alpha is desired, evidence shows that fewer managers are consistently achieving statistically significant alpha in their funds and portfolios over time.

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71 views4 pages

Aplha Beta

Beta is a measure of the volatility of a security or portfolio compared to the market. It represents the tendency of a security's returns to respond to swings in the overall market. Alpha is a measure of performance on a risk-adjusted basis that represents the value added or subtracted by an investment manager compared to a benchmark index after adjusting for risk. Alpha can also refer to the abnormal rate of return of a security or portfolio above what is predicted by the capital asset pricing model based on its risk profile. While alpha is desired, evidence shows that fewer managers are consistently achieving statistically significant alpha in their funds and portfolios over time.

Uploaded by

aakash
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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BREAKING DOWN 'Beta'

Beta is calculated using regression analysis. Beta represents the tendency of a


security's returns to respond to swings in the market.
A security's beta is calculated by dividing the covariance the security's returns and
the benchmark's returns by the variance of the benchmark's returns over a
specified period.
Using Beta
A security's beta should only be used when a security has a high R-squared value in
relation to the benchmark. The R-squared measures the percentage of a security's
historical price movements that could be explained by movements in a benchmark
index. For example, a gold exchange-traded fund (ETF), such as the SPDR Gold
Shares, is tied to the performance of gold bullion. Consequently, a gold ETF would
have a low beta and R-squared in relation to a benchmark equity index, such as the
Standard & Poor's (S&P) 500 Index. When using beta to determine the degree of
systematic risk, a security with a high R-squared value, in relation to its benchmark,
would increase the accuracy of the beta measurement.
Beta Interpretation
A beta of 1 indicates that the security's price moves with the market. A beta of less
than 1 means that the security is theoretically less volatile than the market. A beta
of greater than 1 indicates that the security's price is theoretically more volatile
than the market. For example, if a stock's beta is 1.2, it's theoretically 20% more
volatile than the market. Conversely, if an ETF's beta is 0.65, it is theoretically 35%
less volatile than the market. Therefore, the fund's excess return is expected to
underperform the benchmark by 35% in up markets and outperform by 35% during
down markets.
Many utilities stocks have a beta of less than 1. Conversely, most high-tech,
Nasdaq-based stocks have a beta of greater than 1, offering the possibility of a
higher rate of return, but also posing more risk. For example, as of May 31, 2016,
the PowerShares QQQ, an ETF tracking the Nasdaq-100 Index, has a trailing 15-year
beta of 1.27 when measured against the S&P 500 Index, which is a commonly used
equity market benchmark.

What is 'Alpha'
Alpha is used in finance to represent two things:
1. A measure of performance on a risk-adjusted basis.

Alpha, often considered the active return on an investment, gauges the


performance of an investment against a market index used as a benchmark, since
they are often considered to represent the markets movement as a whole. The
excess returns of a fund relative to the return of a benchmark index is the fund's
alpha.
Alpha is most often used for mutual funds and other similar investment types. It is
often represented as a single number (like 3 or -5), but this refers to a percentage
measuring how the portfolio or fund performed compared to the benchmark index
(i.e. 3% better or 5% worse).
Alpha is often used with beta, which measures volatility or risk, and is also often
referred to as excess return or abnormal rate of return.
2. The abnormal rate of return on a security or portfolio in excess of what would be
predicted by an equilibrium model like the capital asset pricing model (CAPM).
In this context, alpha is often known as the Jensen index.

BREAKING DOWN 'Alpha'


1. Alpha is one of five technical risk ratios; the others are beta, standard deviation,
R-squared, and the Sharpe ratio. These are all statistical measurements used in
modern portfolio theory (MPT). All of these indicators are intended to help investors
determine the risk-return profile of a mutual fund.
Using alpha in measuring performance assumes that the portfolio is sufficiently
diversified so as to eliminate unsystematic risk. Because alpha represents the
performance of a portfolio relative to a benchmark, it is often considered to
represent the value that a portfolio manager adds to or subtracts from a fund's
return. In other words, alpha is the return on an investment that is not a result of
general movement in the greater market. As such, an alpha of 0 would indicate that
the portfolio or fund is tracking perfectly with the benchmark index and that the
manager has not added or lost any value.
The concept of alpha was born with the advent of weighted index funds like the S&P
500 for the stock market and the Wilshire 5000 for the securities market, which
attempt to emulate the performance of a portfolio that encompasses the entire
market and that gives each area of investment proportional weight. With this
development, investors could hold their portfolio managers to a higher standard of
just producing returns: producing returns greater than the investor would have
made with a blanket market-wide portfolio.
Yet, despite the considerable desirability of alpha in a portfolio, index benchmarks
manage to beat asset managers the vast majority of the time. Due in part to a

growing lack of faith in traditional financial advising brought about by this trend,
more and more investors are switching to low-cost passive online advisors (often
called robo-advisors) who exclusively or almost exclusively invest clients capital
into index-tracking funds, the thought being that if they cannot beat the market
they may as well join it.
Moreover, because most traditional financial advisors charge a fee, when one
manages a portfolio and nets an alpha of 0, it actually represents a slight net loss
for the investor. For example, suppose that Jim, a financial advisor, charges 1% of a
portfolios value for his services and that during a 12-month period Jim managed to
produce an alpha of 0.75 for portfolio of one of his clients, Frank. While Jim has
indeed helped the performance of Franks portfolio, the fee that Jim charges is in
excess of the alpha he has generated, so Franks portfolio has experienced a net
loss. Because of these developments, managers face more pressure than ever to
produce results.
Evidence shows that active managers rates of achieving alpha in funds and
portfolios have been shrinking substantially, with about 20% of managers producing
statistically significant alpha in 1995 and only 2% in 2015. Experts attribute this
trend to many causes, including:
The growing expertise of financial advisors
Advancements in financial technology and software that advisors have at their
disposal
Increasing opportunity for would-be investors to engage in the market due to the
growth of the internet
A shrinking proportion of investors taking on risk in their portfolios and
The growing amount of money being invested in pursuit of alpha
2. CAPM analysis aims to estimate returns on a portfolio or fund based on risk and
other factors. For example, a CAPM analysis may estimate that a portfolio should
earn 10% based on the portfolios risk profile. Yet, supposing that the portfolio
actually earns 15%, the portfolio's alpha would be 5, or 5% over what was predicted
in the CAPM model.
This form of analysis is often used in non-traditional funds, which are less easily
represented by a single index.
Limitations of 'Alpha'
While alpha has been called the holy grail of investing and, as such, receives a lot
of attention from investors and advisors alike, there are a couple of important
considerations that one should take into account before attempting to use alpha.

One such consideration is that alpha is used in the analysis of a wide variety of fund
and portfolio types. Because the same term can apply to investments of such
differing natures, there is a tendency for people to attempt to use alpha values to
compare different kinds funds or portfolios with one another. Because of the
intricacies of large funds and portfolios, as well as of these forms of investing in
general, comparing alpha values is only useful when the investments contain assets
in the same asset class.
Additionally, because alpha is calculated relative to a benchmark deemed
appropriate for the fund or portfolio, when calculating alpha it is imperative that an
appropriate benchmark is chosen. Because funds and portfolios vary, it is possible
that there is no suitable preexisting index, in which case advisors will often use
algorithms and other models to simulate an index for comparative purposes.
Want to read more on Alpha? Check out A Deeper Look At Alpha, Bettering Your
Portfolio With Alpha And Beta, Adding Alpha Without Adding Risk and 5 Ways To
Measure Mutual Fund Risk.

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