A few weeks ago, we provided a brief introduction to the concept of investment “alpha.” Now that school has resumed across the country, we’ll turn our attention to the next letter in the Greek alphabet, “beta.”
You’ll recall that alpha (denoted by the symbol α) is a measurement of an investment manager’s ability to generate returns greater than that of the benchmark against which their performance is measured. If a manager is able to “beat the market,” particularly over long periods of time, investors may be attracted to her fund. The problem with alpha is that it is very difficult to discern whether a manager’s benchmark-beating performance is due to luck or to skill.
We might ask ourselves what is the “market?” Academics and professional investment managers will use a benchmark index to represent the market. Perhaps the most commonly used representation of the market is the Standard & Poor’s 500 index. This index includes the 500 largest companies (based on market capitalization) in the United States. So, if we are searching for large cap(italization) fund managers who can generate alpha, we are likely going to use this index as our reference point.
We need to be careful about how we assess a manager’s performance, however. We cannot simply look at performance in isolation. We also need to know how much risk the manager is taking in their efforts to generate superior performance. Why? Well, if the manager is taking more (or less) risk than is inherent in the benchmark, the comparison will be distorted. We know that risk and return are related. So, we would expect that, over time, a manager taking more risk than her benchmark should outperform it. A manager taking less risk than her benchmark is likely to underperform it. Another way to think about this is that investors “buy” return (positive expected returns) by accepting “risk” (i.e. the chance of loss). The more return you want, the more risk you must accept.
So, we need a way to measure risk, and specifically the risk of the market and the risk of a portfolio that is managed in reference to the market. We now introduce the concept of investment “beta” (denoted by the symbol β). Beta is a measure of the risk of a portfolio compared to the market. The beta of the broad market is considered to be 1. Investments that have risk that is greater than the market will have a beta that is greater than 1. Similarly, investments that have risk that is less than the market will have a Beta that is less than 1.
We would expect an index fund that tracks the broad market to have a beta of 1. Consider the State Street Global Advisors SPDR® S&P 500® ETF (ticker symbol SPY) which, as the name suggests, tracks the Standard & Poor’s 500 index of large US companies. Morningstar’s software tells us, as we would expect, that the fund has a beta of exactly 1. You can see that here.
What about a tool to measure the risk-adjusted return of a portfolio? Stay tuned. We will cover that in a future post.
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