An introduction to the technical risk ratios alpha and beta
Alpha is a risk-adjusted measure of performance. It measures the extent to which a fund developed compared to an index. In other words, it shows whether the fund has performed better or worse than the used benchmark market. Alpha identifies part of the return that was say, not caused by a general market trend.
A positive alpha means that a manager has outperformed the respective benchmark. The higher the alpha, the better the performance of the fund. But of course a positive alpha does not suggest that the respective fund generates a positive return, only that it performers better than the benchmarked index.
The concept of alpha emerged with the development of weighted index funds. Such index funds attempt to emulate the performance of a portfolio that incorporates the whole market, and implies that all positions are proportionally weighted. Alpha gave investors a tool to measure their portfolio managers’ performance more accurately by identifying the active return on their portfolio. This being said will reveal the skill of the manager.
This brings us to another important advantage of alpha. As we know, fund managers charge a management fee. If alpha is not bigger than the fee the manager charges, the investors therefore experiences a net loss. Even though We see a positive performance after subtracting the manager fees, it still does not necessarily mean that value was created for his investors.
Overall, alpha seems like a great instrument, right? But as always there are limitations that need to be considered. First, even though alpha is used to analyze many different fund types, comparing alpha values is only meaningful for funds in the same asset class. Secondly, since alpha relates to its benchmark it is essential to use an appropriate benchmark.
Beta measures the volatility of a fund or portfolio compared to a benchmark market. It indicates whether a security or portfolio is more or less volatile than the benchmark. Beta is calculated using regression analysis, and is used to determine the degree of systematic risk a fund or portfolio bears.
- β < 1 : security is theoretically less volatile than the benchmark
- β = 1 : security is theoretically just as volatile as the benchmark
- β > 1 : security is theoretically more volatile than the benchmark
A fund with a beta of 1.4, for example, is theoretically 40% more volatile than the market, which means that the fund would rise 14% if the benchmark rose 10% and would fall 14% if the benchmark fell 10%. A fund with a beta of 0.8, in contrast, is theoretically 20% less exposed to market swings. Consequently, securities with a β > 1 are riskier but offer a potential for higher returns while securities with a β < 1 pose less risk and therefore lower potential returns.
Beta is a clear and quantifiable measure, but it’s important to distinguish between short- and long-term risk. While beta and volatility are useful to determine short-term risk, they fall short of indicating long-term fundamental risk.