We often hear the terms alpha and beta when talking about investments. These are two different measures that are part of the same equation derived from a linear regression. Don't worry if that sounds complicated, we'll explain it all in this article.
Key Takeaways
- Alpha and beta are two different parts of an equation used to explain the performance of stocks and investment funds.
- Beta is a measure of volatility relative to a benchmark, such as the S&P 500.
- Alpha is the excess return on an investment after adjusting for market-related volatility and random fluctuations.
- Alpha and beta are both measures used to compare and predict returns.
The Equation
If equations make your eyes glaze over, you can skip this part. Meanwhile, we can go straight to the equation if you know some algebra or ever had a class covering regressions in college. The basic model is given as follows:
- y = a + bx + u
Where:
- y is the performance of the stock or fund.
- a is alpha, which is the excess return of the stock or fund.
- b is beta, which is volatility relative to the benchmark.
- x is the performance of the benchmark, which is often the index.
- u is the residual, which is the unexplained random portion of performance in a given year.
Defining Beta
Beta is a measure of volatility relative to a benchmark, and it's actually easier to talk about beta first. It measures the systematic risk of a security or a portfolio compared with an index like the S&P 500. Many growth stocks would have a beta over 1, probably much higher. A Treasury bill would have a beta close to zero because its prices hardly move relative to the market as a whole.
Beta is a multiplicative factor. A 2X has a beta very close to two relative to the S&P 500 by design. It goes up or down twice as much as the index in a given period of time. If beta is -2, then the investment moves in the opposite direction of the index by a factor of two. Most investments with negative betas are inverse ETFs or hold Treasury bonds.
What beta also tells you is when risk can't be diversified away. If you look at the beta of a typical mutual fund, it's essentially telling you how much market risk you're taking.
It's crucial to realize that high or low beta frequently leads to market outperformance. A fund with lots of growth stocks and high beta will usually beat the market during a good year for stocks. Similarly, a conservative fund that holds bonds will have a low beta and typically outperform the S&P 500 during a poor year for the market.
If a stock or fund outperforms the market for a year, it is probably because of beta or random luck rather than alpha.
Defining Alpha
Alpha is the excess return on an investment after adjusting for market-related volatility and random fluctuations. Alpha is one of the five major risk management indicators for mutual funds, stocks, and bonds. In a sense, it tells investors whether an asset has consistently performed better or worse than its beta predicts.
Alpha is also a measure of risk. An alpha of -15 means the investment was far too risky given the return. An alpha of zero suggests that an asset has earned a return commensurate with the risk. Alpha of greater than zero means an investment outperformed, after adjusting for volatility.
When hedge fund managers talk about high alpha, they're usually saying that their managers are good enough to outperform the market. But that raises another important question: when alpha is the "excess" return over an index, what index are you using?
For example, fund managers might brag that their funds generated 13% returns when the S&P returned 11%. But is the S&P an appropriate index to use? The manager might invest in small-cap value stocks. These stocks have higher returns than the S&P 500, according to the Fama and French Three-Factor Model. In this case, a small-cap value index might be a better benchmark than the S&P 500.
Other Greek letters like delta, gamma, theta, and vega are important in more sophisticated financial analysis, particularly for options traders and risk managers, but they are typically not as fundamental for everyday investments as alpha and beta.
There's also a chance that a fund manager just got lucky instead of having true alpha. Suppose a manager outperforms the market by an average of 2% during the first three years of the fund without any extra market-related volatility. In that case, beta equals one, and it might look like alpha is 2%.
However, suppose the fund manager then underperforms the market by 2% over the next three years. It now looks like alpha equals zero. The original appearance of alpha was because of sample size neglect.
Very few investors have true alpha, and it typically takes a decade or more to be sure. Warren Buffett is generally considered to have alpha. Buffett focused on value investing, dividend growth, and "growth at a reasonable price" strategies during his career. A study of Buffett's alpha found that he tended to use leverage with high-quality and low-beta stocks.
Alpha vs Beta: Comparison
Alpha
Alpha is the excess return relative to market volatility.
Alpha evaluates investment performance beyond predicted returns.
Alpha greater than zero suggests outperformance after adjusting for risk.
Beta
Beta measures a security's volatility compared with a benchmark index.
Beta indicates systematic risk that can't be diversified away.
Beta values over one indicate higher market volatility.
What Are Example of High Beta Stocks?
Growth stocks typically tend to have a high beta, indicating greater market volatility.
What Does a Negative Alpha Indicate?
A negative alpha means the investment underperformed relative to its expected return based on its beta.
Why Is Alpha Important for Fund Managers?
Alpha helps fund managers assess whether their investments are outperforming the market after accounting for volatility.
How Can Investors Use Alpha in Their Strategies?
Investors use alpha to identify investments that have consistently outperformed their expected returns, adjusting for risk.
The Bottom Line
Alpha and beta are fundamental concepts in finance that help investors measure and understand the performance and risk of investments relative to the broader market. Beta, often considered first, quantifies an asset's volatility or systematic risk compared to the market as a whole. A beta of one indicates that an investment tends to move in line with the market, while a beta greater than one suggests higher volatility, and less than one implies lower volatility than the market. This metric is crucial for investors in assessing the potential risk of an investment and its role in portfolio diversification.
Alpha, meanwhile, measures the excess return of an investment compared with a benchmark index, after accounting for beta. In essence, alpha is the value that a portfolio manager or investment strategy adds above what would be expected given the investment's level of market risk. A positive alpha indicates outperformance, while a negative alpha suggests underperformance relative to the benchmark.
