Alpha and beta explained
An investment’s return stream is composed of what can be described as small building blocks – known in finance as alpha and beta. The term “alpha”1 refers to the part of the return that is not easy to identify or invest in, including stock-specific idiosyncrasies or the unique skill and experience of a particular fund manager. Alpha is the je ne sais quoi of the return stream. The term “beta”2 refers to the part of an investment’s return that is more easily identifiable. Also known as “risk premia,”3 it denotes things like investment sector, style, size, and general market risks. In short, “beta” is what is expected, while “alpha” is the additional return.
The (Alpha and Beta) Theory of Evolution
Generally speaking, beta is readily describable, while alpha is not. However, over time, unidentified components of a return stream can be identified – allowing alpha to evolve into beta. For example, investment professionals historically lumped large and small companies together, not realizing that company size could be a factor driving risk and return characteristics. Today, they acknowledge that small companies have generally outperformed large companies over time, but have tended to do so with more volatility. Thus, small companies offer a unique risk and return profile – and have become an identifiable source of beta.
Creating alternative beta
Beginning in the 2000s, financial engineers began to develop ways of capturing the betas of hedge fund returns by using regression techniques on large datasets of hedge fund strategies. In mathematics, regression is the practice of finding relationships between a group of variables. For example, analysts began to mathematically solve for how much exposure a collection of long/short equity funds had to different economic sectors over time.
As time went on, the previously obscure and proprietary methods of analysis that helped some hedge fund managers achieve outperformance became more mainstream. Alternative alpha had begun to evolve into alternative beta. Once these techniques were broken down into a system of rules, they could be automated by computer programs, and the alpha trades of yesterday became the beta trades of today. The only reason the term “alternative” is applied for today’s classification is to identify it as something other than conventional equities and fixed income.
Seeking additional return and diversification
It’s important to note that hedge fund strategies can be run using both passive and active models. A portfolio manager’s unique skill and knowledge may lead to different outcomes than a passive trading algorithm that relies solely on what it can derive by scraping databases. Nevertheless, hedge funds use a variety of strategies to capture alpha, and many of these alphas can now be mechanically replicated in order to provide alternative beta in a more accessible mutual fund format. Financial professionals may be well served by funds that rely on hedge fund beta as an additional source of return potential and diversification.
2 Beta measures the volatility of a security or a portfolio in comparison to the market as a whole.
3 Risk premia is a form of compensation for investors who tolerate extra risk, compared to that of a risk-free asset, in a given investment.
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Diversification does not guarantee a profit or protect against a loss.
Alternative investments involve unique risks that may be different from those associated with traditional investments, including illiquidity and the potential for amplified losses or gains. Investors should fully understand the risks associated with any investment prior to investing.
This material is provided for informational purposes only and should not be construed as investment advice. The views and opinions expressed above may change based on market and other conditions. There can be no assurance that developments will transpire as forecasted.
All investing involves risk, including the risk of loss. Investment risk exists with equity, fixed income, and alternative investments. There is no assurance that any investment will meet its performance objectives or that losses will be avoided.