It’s all Greek to me

July/August 2010

The world of financial services is littered with incomprehensible jargon but perhaps two of the most commonly used and confused terms are ‘alpha’ and ‘beta’.

What are alpha and beta?

Understanding alpha first requires an explanation of beta. Beta describes how similarly an investment fund behaves to (or ‘correlates with’) the performance of the underlying market (such as the FTSE 100). Investments that aim to capture beta can be described as ‘buying the market’ as the fund contains all the good and bad investments in that market.

To achieve beta returns, an investor only needs to invest passively in an index or benchmark (see below). It requires no skill on the part of the investment manager and can be achieved through investing in an index-tracking fund, or increasingly in exchange traded funds (ETFs). Index-tracking funds are often managed electronically so there is little input from an investment manager – and fees are low.

Alpha refers to the returns an asset manager produces relative to those available in the market, referred to as outperformance of the benchmark. An alpha-generating, or active, asset manager attempts to use his or her skill to ‘beat the market’. Many strategies exist; the common thread is that the returns result from the manager’s decisions.

Managers can produce alpha in a variety of ways. For example in a UK-based fund this could include shifting allocations to different stocks within a portfolio according to the market cycle (as different types of business will do well in different types of economic conditions). For global funds, an active manager might vary the balance of shares from different international markets depending on economic factors in those countries. Other managers might rely simply on picking the best mix of stocks based on their own experience and research. Alpha returns should not be correlated (or at least have a low correlation) with the market.

Crucially, alpha refers to risk-adjusted returns – meaning the extent to which the manager can beat the market without taking significantly more risk than other products in the market. It is easy to increase expected returns (for example by using debt to boost returns) by taking more risk – but this is not alpha. The credit crisis exposed many supposedly alpha-generating funds using such practices and trustees got an unwelcome surprise when they found that their fund was more correlated with the market than they thought.

Why invest in beta-generating assets?

Investing to target beta allows pension funds to benefit when an index rises. Over the long term, it is assumed that equity investments will produce positive returns (otherwise no one would invest). Although the experience of the last two years suggests otherwise, investors can generally profit over the long term from riding out short-term falls in the market while benefitting from a steady overall rise in value. By their nature, passive funds do not require much work on behalf of the asset manager so fees are low in comparison to actively managed funds.

Why invest in alpha-generating funds?

The capacity of a skilful investment manager to beat the market is reliant on the efficiency of the market. Efficiency in this context means the correct pricing of equities, defined by how much of the publically available information is reflected in the share price. A highly liquid and avidly-analysed market such as the Dow Jones Industrial Average, containing the 30 largest US stocks, is said to be highly efficient. This means that a fund manager is likely to struggle to generate alpha in this market. If that is the case, what is the point in paying higher fees?

Trustees should invest with an active fund manager if they are convinced that that it will produce better returns that the market. The flip-side of the Dow Jones example is that inefficient markets should prove fertile hunting grounds for active managers. Active managers of emerging market funds often suggest that they benefit from face-to-face meetings with companies and performing due diligence more than managers in better regulated markets. However, whether the assumed protection justifies the fees is a moot point. Investors effectively have the choice of taking the occasional financial hit that could have been prevented or face a constant stream of management fees to prevent these losses.

Active managers are able to offer exposure to markets that are not practically covered by passive strategies such as frontier markets, including Vietnam or sub-Saharan Africa, or market segments where no benchmarks exist. In addition, a pension scheme’s investment decision may not be solely about returns; active managers can follow strategies that fit in with the scheme’s broader aims or complement its other investments.

Can asset managers really capture alpha?

By definition, for every asset manager that beats the market there must be one that loses out relative to the market. The winners and losers must balance out to preserve the market average return (which is available from a passively managed fund). Nizam Hamid, head of sales strategy of iShares International says: “Ultimately, if you look at the market as a whole, it has to be a zero-sum game. You cannot have all managers outperforming the market, by definition.”

This means that, if a pension scheme picked an actively managed fund at random it would have a 50% chance of beating the market (before the cost of fees is deducted) and 50% chance of losing to the market. Trustees therefore need to be confident that they are able to pick a winning rather than losing manager. Consultants suggest that selection and due diligence can improve the scheme’s chances of picking a winning manager. Picking good managers is easier said than done however: no-one knowingly chooses a losing manager.

Past performance is not necessarily a guide to the future, as they say. It is important to consider returns over the whole economic cycle. For example an aggressive manager may regularly beat the market during a boom but lose more than the general market during the downturn. Be warned: asset managers will always present returns in the most favourable timeframe for their products.

How to select investments

One may be surprised by the amount of active managers that claim to be in the ‘top quartile’ of funds. They can be both telling the truth and be benefitting heavily from selection bias, which results from unsuccessful funds closing. Consider an asset manger that launches 10 funds with randomly selected assets; five will beat the market and five will not. The losing ones are quietly closed while the winners can be marketed on the stellar performance of the manager – but the chance of beating the market next year is still only 50%, or less given fees.

It also needs to be remembered that a fund’s performance may change over time due to a changeover of management. Successful managers quickly gain reputations in the financial world and become targets for other investment management companies. Trustees need to be confident that such ‘star managers’ are likely to remain with the fund for the duration of their investment.

A common strategy is for pension schemes to have their core holding in beta-generating funds and take more modestly sized stakes in alpha-generating investments. It makes sense for such core beta-capturing investments to be in the large, liquid efficient markets (such as the FTSE 100 or Dow Jones Industrial Average) while alpha-capturing ones could be focused on more obscure parts of the world or more unusual asset classes.

As actively managed funds provide some degree of return uncorrelated to the market, holding a variety of actively managed funds can aid the overall diversification of the scheme’s assets. This will especially be the case if the manager is following a particular investment strategy, such as a global recovery fund which concentrates on shares that do well as the world emerges from recession.

If active managers only beat the market half of the time and they charge higher fees for doing so, the manager would have to be exceptional for the investment to be a good one. Some active managers can no doubt regularly beat the market and provide great opportunities when they appear but they are few and far between.