The Beta indicates how each security/manager has or should perform in relation to movement by any primary index. Beta is the "slope" of the regression line or the amount of change on the vertical axis (security return) per unit of change on the horizontal axis (Index return). If the slope is 45 degrees, the beta is 1.0 which means that, on average, every one percent change in the security/manager's return was associated with a one percent change in the Index return. A Beta greater than 1.0 indicates a higher level of risk and an expected change in value in excess of that experienced by the primary index. For example, if a security had a beta of 1.6, that means over the past five years, the stock has moved 60 percent greater than the benchmark, both up and down.

 

In calculating Alpha, the formula for the slope of a line: a + bx = y.   If Beta is set at zero, thereby eliminating market price volatility, alpha will measure the investment return for a particular security when compared to a benchmark.   Alpha indicates the change in value for an asset/manager which is independent (or unrelated) to a change in value for the primary index. Alpha measurements that are positive (e.g., plus 1.0) means that a particular security will yield returns 1.0 percent greater than the average of the benchmark.

 

For example, using a screening function, such as the one in AdvisoryWorld’s ICE application, you will find funds that have been classified as "Large Company Growth" style (using a regression against the index). 

 

Take all of the funds exhibiting a style representative of Large Company Growth, with an Alpha above 1.0 and you will find that all of them will have performed above the 50th percentile using the 1 year annualized RORs. Depending on the time frame, you will likely find that 60%-70% of these funds were above the 50th percentile using 3 year annualized RORs, and for the ten year period 50%-60% were above the 50th percentile. In each period the funds with Alphas above 1.0 will have outperformed funds with Alphas of less than 1.0. In fact, in one such analysis, the average 1 year return for funds with Alphas greater than 1.0 was 4.14% more than for the average for funds with Alphas of less than 1.0. That is a remarkable performance differential!

 

In up or flat stock markets we have found that funds with Alphas greater than 1.0 tend to substantially outperform their Indexes. Almost 95% of these funds beat the Index over a 3 year time frame and 57.60% beat the Index over a five year time period. Interestingly, during a ten year horizon which included a major Bear Market (2000-2002), these funds tended to only slightly outperform the Index. Consequently, while funds with greater alphas will outperform funds with lower alphas, they may not outperform their respective indexes during periods of down markets. This would imply that ETFs (Exchange Traded Funds) might be the better choice during periods of market uncertainty. In an article titled "Separability of Alpha and Beta", Victor Canto of LaJolla Economics came to a similar conclusion. It is worthy of note that in all of these periods, the funds with alphas in excess of 1.0 substantially outperformed funds with alphas of 1.0 or less.

 

Professional investors are familiar with the concept that we would prefer to be in funds with low betas (less than 1.0) during down markets and in funds with high betas (greater than 1.0) during rising markets. But, is this consistently true if we are using funds with alphas greater than 1.0 and specifically greater than 5.0? There doesn't appear to be any correlation of returns between funds with similar alphas and varying (higher or lower) betas. In other words, having a high alpha and a lower beta (less than 1.0) doesn’t necessarily imply a lower ROR than a fund with the same or similar alpha and a high beta (greater than 1.0).

 

In general all funds/securities with an alpha greater than 5.0 and a beta less than1.0 performed above the 50th percentile for the 3 & 5 & 10 year periods (which included the Bear Market of 2000-2002).

 

For a white paper discussing the benefits of Alpha, or to review the ICE application, contact Philip Wilson at This email address is being protected from spambots. You need JavaScript enabled to view it..