Generating Alpha

As discussed in this recent article more investors are switching index funds or using low cost tools such as robo advisors. This trend towards so called “passive” investing is due in part to a growing lack of faith and poor performance in traditional active money managers and financial advisors. The general notion is if you can’t beat the market you might as well just join it.

In the article I misused the word “beta” in making the case “the shift towards passive investing, as it becomes not only self-reinforcing but also makes rising above the pack, or creating beta, more difficult.”  I actually meant to say creating “alpha”, to express a money manager outperforming a given index or benchmark.

Given my belief the pendulum towards passive investing is on the verge of swinging too far, let’s use my mistake as opportunity to explore the concept of alpha and how we can go about generating it.

What is Alpha?

According to Investopedia, Alpha is “Alpha, often considered the active return on an investment, gauges the performance of an investment against a market index used as a benchmark since they are often considered to represent the market’s movement as a whole. The excess returns of a fund relative to the return of a benchmark index is the fund’s alpha.”

Now how did I get this term confused with beta? Beta, referred to a stock or asset that has a tendency to move more than the broader sector or asset class it is part of. For example, our benchmark of then S&P 500 Index a stock that tends exactly in line with it will have a beta of 1.0.   The SPY ETF has a near perfect beta of 1.0 to the S&P. In one sense beta is similar to a stock’s volatility.

A highflying momentum stock Nvidia (NVDA) currently has a beta of 1.5%, meaning over the course of a year it is expected to move nearly 50% more than the S&P 500.

A slow moving utility such as Consolidated Edison (ED) has a beta of 0.3 meaning it is expected to only one third ( 70% less) than the S&P 500.

One can see that stuffing a portfolio full of high beta stocks is one way to generate alpha. But it doesn’t guarantee it. It may also lead to greatly underperforming the market or your benchmark.

Remember Alpha refers to the outperformance or the value that a portfolio manager adds fund’s return. This could also come in the form of risk reduction. In other words, alpha is the return on an investment that is not a result of general movement in the greater market.

In fact investors can use both alpha and beta to judge a manager’s performance. If the manager has had a high alpha, but also a high beta, investors might not find that acceptable, because of the chance they might have to withdraw their money when the investment is doing poorly.

The most common way for money managers, or individual investors for that matter, to add alpha without creating too much beta or volatility to their portfolio simply overweighting a few that are within the index is by adding a handful of names that are not within the benchmark index.

This give the portfolio a far degree of tracking the index ( a beta near 1.0) but have the ability to generate alpha should the particular additions (or subtractions) outperform. If and when we get back to a “stock picker’s” market. We’ll find out who can add alpha.

— The Option Specialist

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About the Author: The Option Specialist