Learning Centre
What are Alpha and Beta? (November 2009)
Sunday, November 01, 2009
Beta is a financial term used to measure an equity or portfolio’s historical volatility compared to the market as a whole over a given period. It is a tool investors can use to assess the risk profile of potential investments, relative to the overall market. Keep in mind that beta is backward looking, therefore future expectations may not coincide with past performance.
A beta of 1.0 would imply that historically the change in value of the equity or portfolio would be exactly the same as changes in the value of the overall market. A beta greater than 1.0 would suggest that the equity or portfolio has moved more than the market, in either direction. On the other hand, a beta of less than 1.0 would indicate an equity or portfolio has moved less than the market. For example, if the market goes up 8% in a given period and an equity has a beta of 1.5, then theoretically the expected move of the equity would be 12% (8% x 1.5 = 12%). In another example, if there is an equity with a beta of 0.6 and the market returns -15%, it would imply the equity return would be -9%.
Alpha is the excess return of the fund, adjusted for risk, relative to the return of the benchmark. For example, consider a portfolio with a beta of 0.80 and a return of 6%, versus a market return of 5% over the same period. The expected return of the portfolio, accounting for its lower risk level versus the broader market, would be 0.80 x 5% = 4%. The portfolio's outperformance of 2% (6% actual vs. 4% expected), is generally considered alpha, or active return.
Alpha can be achieved through a number of means including sector allocation and security selection (i.e. over/underweighting sectors or individual securities as compared to the market). Positive alpha is ultimately what active money managers are trying to achieve.