Alpha and beta are two key coefficients in the capital asset pricing model used in modern portfolio theory. An asset's exposure to unsystematic risk is measured by its beta (β). Indicating whether it's more or less volatile than the market. The excess return of an investment relative to the return of a benchmark index is the investment's alpha (α).
"A practical way of thinking about beta is that it's the kind of return that you can get on demand," says Theodore Enders, portfolio strategist at Goldman Sachs Asset Management. “Alpha is more complex, because it can be identified only with hindsight.”
Not everyone’s a fan of the concept.
“Investors should be sceptical of history-based models constructed by a nerdy-sounding priesthood using esoteric terms such as beta, gamma, sigma and the like,” warns Warren Buffett. “These models tend to look impressive, all too often, though, investors forget to examine the assumptions behind the models.”
“The alpha/beta framework has given rise to the obsession with benchmarking,” says James Montier, “and indeed a new species, Homo Ovinus, whose only concern is where to stand relative to the rest of the crowd.”
John Szramiak at Business Insider thinks it’s a ludicrous concept and finds it upsetting that it's still taught in business schools. First of all because beta uses market prices to measure risk - instead of using fundamentals. “Market prices often have nothing to do with the underlying economics of a business. So how can market prices tell us anything about the riskiness of a business?” Secondly, because the theory claims that a stock whose price has dropped by a large amount is riskier than a stock whose price hasn't dropped as much. “But if the underlying economics of a business hasn't changed,” says Szramiak, “has that business suddenly become more risky? Definitely not! In fact, the stock would now have a higher margin of safety and should properly be considered less risky.”
As Warren Buffett explained in the Fall 1984 issue of Hermes: “The Washing Post Company in 1973 was selling for $80 million in the market. At the time, that day, you could have sold the assets to any one of ten buyers for not less than $400 million, probably appreciably more. The company owned the Post, Newsweek, plus several television stations in major markets. Those same properties are worth $2 billion now … Now, if the stock had declined even further to a price that made the valuation $40 million instead of $80 million, its beta would have been greater. And to people who think beta measures risk, the cheaper price would have made it look riskier. This is truly Alice in Wonderland. I have never been able to figure out why it’s riskier to buy $400 million worth of properties for $40 million than $80 million.”
“For value investors who like to buy dollar bills for fifty cents and are even happier to buy them at forty this will be easy to understand,” quipped Buffett.
Alpha also has its detractors.
“The ultimate big game hunt on wall Street is the quest for “alpha’”, says Susan McGee in her book Chasing Goldman Sachs “Technically, it’s a return that can’t be explained by what’s going on in the market. So, if the S&P 500 is up 10 percent and the manager posts a 15% return, that extra 5 percent is, theoretically at least, pure alpha. The problem is that the more you look for alpha. The harder it is to find, just like your missing car keys. Some folks argue that it’s less like a big game and more like looking for the dodo bird – in other words, it has been hunted into extinction by all the edge funds.”
On the other hand if you buy an index fund, your alpha is 0%. Theoretically, your alpha is negative by the cost of owning the fund. In other words, despite all the praise over index fund investing, you are bound to underperform your respective index. You’re chasing guaranteed underperformance.
At least by investing in an actively managed fund – “chasing alpha” - you have a chance of outperformance.
How much of a chance? “Sometimes it seems as if it would be easier to pin Jello to a wall-or trap a unicorn-than it would be to capture alpha,” says McGee.
The good news is that most of us don’t need to chase alpha (or even try to understand what it really is) as we don’t need to beat the market.
“While it would be really nice to generate consistent excess return I suspect that ‘alpha’ is not posted on your refrigerator as one of your long-term financial goals,” reckons Cullen Roche at Pragmatic Capitalism. “Most asset allocators just want to generate a return that outpaces inflation and doesn’t expose you to excessive volatility. If that’s in line with your personal financial goals, you are achieving your own personal sort of alpha. In this sense it’s more important for investors to generate the appropriate type of return rather than the highest return.”
The bottom line: We should be careful not to create benchmarks that are inconsistent with the appropriate goals that we should be setting ourselves.
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