• Alpha and Beta are metrics used to provide a historical measurement of the past performance of an individual asset or a portfolio of assets.
• Alpha refers to performance as compared to a given benchmark index, while Beta refers to the volatility of an asset compared to the market in general.
• While a high alpha is usually considered good, the desirability of a high beta varies depending upon an investor’s overall goals.
The terms alpha and beta refer to a pair of performance measurements of an equity, a fund, or a portfolio of investments. An investment’s return when compared to an index is considered its alpha. An investment’s volatility measurement is referred to as its beta, which can be used to grade the relative risk an investment presents.
Basically, the two calculations are employed to evaluate the historical returns of an individual investment or a portfolio of investments.
The beta coefficient of an equity, fund or portfolio is an expression of its volatility as compared to the market in general. In most instances the S&P 500 is used as the benchmark against which the measurement is taken. Having a measure of the volatility of an asset can help investors get a sense of the risk that asset entails as an opportunity.
The baseline measurement is one wherein the price of an asset moves in sympathy with the benchmark. A measure of less than numeral one indicates that the asset’s volatility is less than that of the benchmark. A number greater than one means its volatility is greater than that of the benchmark.
For example, a beta of 1.7 means the asset’s volatility is 70% greater than the benchmark against which it is measured. A beta of .7 means its volatility is 70% less than that of the benchmark.
Here too, it should be noted that this number represents the historical performance of the asset, rather than a prediction of its future behavior. With that said, the beta can be used to help an investor determine how an asset aligns with their overall goals.
A lower beta means that an asset has been less volatile and therefore could be a good investment for an individual looking for income rather than growth. Investors more focused on growth would likely find an opportunity with a high beta more promising.
Beta = CR/Variance of Market’s Return
Where CR= Covariance of an asset’s return with market’s return
The Role of Alpha in Finance
Usually represented as a single number with either a positive or a negative value, the alpha figure is a representation of the performance of an investment compared to a given benchmark.
For example, an investment with an alpha of seven outperformed its comparative index by 7%. An investment with an alpha of -7 underperformed its comparative index by 7%. An investment with an alpha of zero performed in sync with its benchmark.
While this can be a useful tool, it is important to note that the nature of an alpha means it can only measure past performance. While the figure is useful to evaluate the past performances of an investment over a given period, relying upon it to predict future returns is inadvisable.
Portfolio managers use alpha to gauge the rate of return based upon a capital asset pricing model or CAPM. The CAPM provides an indication of the expected return of an investment as compared to the risk the investment poses.
The formula for calculating CAPM is as follows:
Expected Return = Risk-free rate + (Beta x Market Risk Premium)
Expected Return = Anticipated return of an asset over time
Risk-free rate = Yield on a 10-year US government bond
Beta = Volatility as measured against the overall market
Market Risk Premium = Return over and above the risk-free rate
This metric enables portfolio managers to perform a rate of return calculation to determine whether a portfolio’s performance exceeds the CAPM’s prediction or falls short of it. For example, a portfolio whose CAPM analysis indicates a 7% return would be considered to have an alpha of -4% if its actual return was 3%.
An alpha is calculated according to the following formula:
|Alpha = (End Price + DPS − Start Price)/ Start Price|
|Where: DPS = Distribution per share|
Given that alpha represents the performance of an investment as compared to a benchmark, the figure can also be said to be a measure of the value a portfolio manager achieves. If the alpha of a portfolio is zero, it is said to have tracked the performance of its benchmark exactly. This means the portfolio manager added no value. On the other hand, it also means the manager costs the portfolio no value. A positive alpha means the manager added value to the portfolio, while a negative alpha means the manager decreased the value of the portfolio.
The Harvard Business School website offers a database of current and historical alphas as well as current and historical betas. It also includes alphas and betas for mutual funds.
Individually selecting exposure to alpha and beta can help an investor maintain the desired level of risk a portfolio represents through diversification, which is generally agreed upon by advisors to be a smart investment strategy to pursue.
This strategy can provide more control over the total risk to which an investor is exposed. It also gives the investor the ability to determine the most advantageous level of exposure in alignment with their overall goals.
Alternative investments can also be potentially useful tools for portfolio diversification Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings.
Real estate, private equity, venture capital, digital assets, and collectibles are among asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification.
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Essentially, alpha and beta are metrics that can be employed to compare and predict potential returns. Alpha refers to performance as compared to a given benchmark index, while beta refers to the volatility of an asset compared to the market in general. Taken together, they represent the risk ratios an investor can use to gauge potential returns.
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