ALPHA AND BETA
INVESTING

Alpha and beta are powerful analytical tools that can provide insights into how investments may perform relative to the market and how much volatility they may carry. This article will guide you through understanding these metrics, interpreting their values and applying them to your investment strategy.

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When evaluating investments, understanding how to measure both performance and risk is crucial for making informed decisions. Alpha and beta are two fundamental metrics that can be used to help investors assess these critical aspects of their portfolios.

What are Alpha and Beta?

Alpha and beta are statistical measures that help investors evaluate different aspects of investment performance. Alpha measures the excess return of an investment compared to a benchmark index, while beta measures the volatility or systematic risk of an investment relative to the overall market.

Think of alpha as your investment’s “value added” score — it tells you whether an asset, fund manager or investment strategy is outperforming what you’d expect given the level of risk taken.

• A positive alpha indicates outperformance, while a negative alpha suggests underperformance.

Beta, on the other hand, acts as a volatility gauge.

• A beta of 1 means the investment moves in line with the market, while values above or below 1 respectively indicate greater or lesser volatility.

These metrics originated from the Capital Asset Pricing Model (CAPM), developed in the 1960s. Today they’re essential tools for both professional fund managers and individual investors seeking to understand their portfolio’s risk-return characteristics.

Understanding Alpha in Investing

Alpha represents the active return on an investment, measuring performance against a market index or benchmark. When you see an alpha of 2%, it means the investment has outperformed its benchmark by 2% after adjusting for risk.

Alpha is particularly valuable for evaluating actively managed funds and investment strategies. Calculating it involves comparing actual returns to expected returns based on the investment’s beta. The formula considers the return of a benchmark return, for example the rate of return of government bonds which is a relatively low-risk investment and the investment’s return.

Factors to consider when using Alpha

When evaluating alpha it is important to consider what benchmark you are comparing performance against, the timeframe you are using and what factors may be responsible for the alpha rating.

• Always check which benchmark is being used. It is probably better to compare a UK equity fund to a relevant UK index such as the FTSE 100 (UK100) rather than a global index.
• It’s also important to note that alpha can vary significantly over different time periods. A fund might show positive alpha over one year but negative alpha over five years.
• Keep in mind as well that outperformance could be attributed to random factors rather than the investment skills of an investment manager.

Understanding Beta in Investing

Beta measures how an investment’s price movements correlate with the broader market. This metric helps investors understand the systematic risk they’re taking on.

A beta of 1.0 indicates the investment moves in perfect correlation with the market — if the market rises 10%, the investment is expected to rise 10% as well.

Investments with beta greater than 1.0 are considered more volatile than the market. For instance, a stock with a beta of 1.5 would theoretically rise 15% when the market gains 10%, but would also fall 15% when the market drops 10%. Conversely, investments with beta less than 1.0 are less volatile. Defensive stocks like utilities often have betas below 1.0, making them popular during market downturns.

Factors to consider when using Beta

Understanding beta helps in portfolio construction and risk management.

• High-beta investments can amplify returns in bull markets but increase losses during downturns.
• Low-beta investments provide more stability but may underperform in strong markets.

The key is matching beta exposure to your risk tolerance and investment timeline.

Using Alpha and Beta Together in Investment Analysis

While alpha and beta provide valuable insights individually, using them together creates a more comprehensive picture of investment performance. Alpha tells you about excess returns, while beta reveals the risk taken to achieve those returns.

Employing a strategy which considers both alpha and beta helps investors make better informed decisions aligned with their goals. Consider two funds:

• Fund A has an alpha of 3% with a beta of 1.5.
• Fund B has an alpha of 2% with a beta of 0.8.

Fund A generates higher excess returns but with significantly more volatility. Fund B provides lower excess returns but with less risk. The “better” choice depends on your risk tolerance and the market outlook. During periods of increased market volatility, Fund B’s lower beta might be preferable despite its lower alpha.

Professional investors often use alpha and beta to construct diversified portfolios. They might combine high-alpha, high-beta growth investments with low-beta defensive positions to balance risk and return. This approach allows for potential outperformance while managing overall portfolio volatility.

Practical Applications for Active Traders and Investors

For active traders, alpha and beta serve as essential screening tools. Traders seeking momentum plays might filter for high-beta stocks (above 1.2) during bull markets, while those prioritising capital preservation might focus on low-beta investments (below 0.8) during uncertain times.

Long-term investors can use these metrics for portfolio rebalancing and risk assessment. If your portfolio’s overall beta has crept above your comfort level due to market changing market dynamics, you might rebalance toward lower-beta investments. Similarly, consistently negative alpha in actively managed funds might prompt a switch to lower-cost index funds.

Traders who adopt more speculative short-term strategies may target high-alpha markets as these are associated with more volatile price moves. Whichever approach you use, alpha and beta should be used alongside other analytical tools like fundamental analysis and technical indicators to ensure investment decisions are based on a comprehensive analysis.

Using Alpha and Beta on eToro

Trading platforms like eToro typically provide alpha and beta metrics for stocks and funds. The readings for the metrics will change in real-time and can be tracked using the stats page of the instrument you are monitoring. The below example shows a beta reading for Tesla of 2.1123.

Source: eToro

Past performance is not a reliable indicator of future results.

Final thoughts

Mastering alpha and beta analysis allows investors to use powerful tools to evaluate risk-adjusted returns and build portfolios aligned with their financial objectives.

Remember that these are just two pieces of the puzzle. Pieces which need to be considered within the context of your overall investment strategy and goals.

Visit the eToro Academy to learn how to build a portfolio which matches your investment aims.

FAQs

Are alpha and beta reliable indicators for future performance?

Alpha and beta are based on historical data and don’t predict future performance. Market conditions change, and past relationships may not hold. Beta tends to be more stable over time than alpha, but both can shift, especially during market regime changes. Use them as part of a broader analytical framework, not as your sole decision-making tools.

What’s considered a “good” alpha or beta value?

A positive alpha is generally desirable, with anything above 0% indicating outperformance. For beta, “good” depends on your objectives – conservative investors might prefer beta between 0.5-0.8, while aggressive investors might seek beta above 1.2. The key is alignment with your risk tolerance and investment goals.

Can alpha be negative and still represent a good investment?

Yes, an investment with negative alpha might still be valuable in a portfolio context. For instance, a low-beta investment with slightly negative alpha could provide valuable diversification and downside protection during market corrections, making it worthwhile despite underperforming its benchmark.

How can beta be incorporated into an investment strategy?

Disciplined investors with a long-term investment horizon can use beta as part of a strategy which assumes that market corrections are inevitable, but have confidence that long-term returns of the stock market will exceed returns on risk-free assets. During market wide slumps, high-beta stocks will overshoot to the downside. Buying into positions using dollar cost averaging techniques would allow entry into positions at prices lower than the long-term average, assuming of course that the market does ultimately recover.

When can high alpha be a “bad” sign in a stock?

A stock may record high alpha for reasons which reduce its potential for long-term returns. A stock price rise over the previous twelve-months could be attributed to a company’s management taking excessive risks or asset stripping to justify short-term returns to investors. Such events highlight the importance of knowing the difference between value and price as once they become public knowledge the price of the stock could fall.