Jargon Busting: Alpha and beta

Jargon Busting: Alpha and beta

This week we explore the concepts of investment alpha and beta – concepts deemed so highbrow that they are deserving of a Greek letter apiece.

With disregard for common order, we begin with beta. This attempts to measure the historic sensitivity of an investment relative to a benchmark or index.

In the equity world, this is the amount that a given share (or portfolio) rises or falls relative to the wider market. Beta is terribly simple and there are only two things about it you need to know.

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Firstly, is it positive or negative? This tells us if the share typically moves the same way as the market. (Negative beta is rare outside of the hedge world.)

Secondly, is it higher or lower than one? This tells us if the moves have been more or less than the benchmark. As Bruce Forsyth used to say, ‘That’s all there is to it.’

A couple of examples: Kaz Minerals – the Kyrgyzstani mining company – has a high beta of 2.2.

This is most certainly a stock with above-average risk. In contrast, Imperial Tobacco Group has a relatively low beta of 0.5 – the world’s smokers do not tend to vary their inhalations based on the economy, and so Imperial Tobacco shares tend to be less sensitive to general market conditions.

Alpha, on the other hand, attempts to be clever. It measures the return that a portfolio has generated in excess of what would have been expected given its beta. A portfolio with a beta of one should produce a return equal to the market. Any miraculous outperformance is deemed to be alpha.

For example, the Lindsell Train UK Equity fund (a favourite of ours) has a beta of 0.9, so should have returned 90 per cent of the return of the market.

Instead, it has outperformed the market by around 9 per cent in the past 12 months, according to data from FE Analytics. That is what we all seek: better performance for less risk.

Alpha and beta breakdown the performance of a portfolio into two parts: the return received in compensation for taking market risk (beta), plus the excess return generated over and above that (alpha).

Alpha is thus a particularly pertinent concept for active investing. An active manager’s charges are justified on his or her ability to produce alpha.

Cheap passive investing with an index tracker will always have near-zero alpha, since the fund and the market are one and the same. In fact, the tracker’s ‘alpha’ will be slightly negative, since fees mean the tracker will underperform the index.

Predictably, these concepts do face criticisms. The values for alpha and beta are determined by the market or benchmark against which you are measuring the fund.

Much as the cassowary will score nul points when judged on its ability to fly, we do protest that many investment benchmarks are really rather poor yardsticks.