Jargon Busting with Hawksmoor: Alpha & Beta
Alpha & Beta
With disregard for common order, we begin with beta. Beta measures an investment’s historic sensitivity relative to a benchmark: the rises and falls compared to the wider market. Beta is simple and there are only two things to know: first, is it positive or negative? This tells us if the portfolio typically moves the same way as the market. Second, is it higher or lower than one? This tells us if the moves have generally been greater or less than the market. As Brucie used to say, that’s all there is to it.
Alpha, meanwhile, attempts to be clever. It measures the return generated in excess of that expected by a portfolio’s beta. A portfolio with a beta of one should produce a return equal to the market; out-performance must be miraculous alpha, the holy grail of investing: better performance for less risk.
Alpha and beta thus split performance into two parts: the return from taking market risk (beta), plus the excess return generated over and above that (alpha). An active manager justifies his fees on their ability to produce alpha. Passive investing, where the fund and the market are the same, will always have near-zero alpha.
Yet be careful: picking a relevant benchmark is crucial. Much as the cassowary scores nul points judged on its ability to fly, many investment benchmarks are really rather poor yardsticks. The nature of benchmarks can also change: olde-worlde blue chips looked terribly risky in the dotcom era judged by alpha-beta when the dotcom-dominated market raced upwards. In the real world, the businesses were just as profitable.
For more information visit Hawksmoor Investment Management at: www.hawksmoorim.co.uk/