Alpha: Putting investment return in the context of risk
Joel Dresang: Kyle, when you’re looking at an investment portfolio, beta measures the risk of the portfolio relative to a benchmark. Alpha measures return. Can you explain for us what that means?
Kyle Tetting: It’s not as simple as just return, but yeah, it really is return in excess of a given level of risk. So, you mention beta. It’s the portfolio’s return in excess of that beta.
Joel: So I have an investment that’s based on an index, and that index is also what the beta is measured on. How would that show up in alpha?
Kyle: So if you have an index investment, your alpha generally is going to be zero because the index itself and the investment itself, is the same. You’re not going to add any value over and above that level of risk.
Joel: And if I paid fees, that would mean that I would have a negative alpha?
Kyle: That’s right. Because you can’t invest in those indexes directly. You have to go through some investment company to get them. You’re paying management expenses for them to track that index. Now, all of a sudden, you’re actually losing value, relative to that index.
Joel: So I’d be getting below-average returns for average risk.
Kyle: That’s absolutely right. That’s really the big problem with index investing is that you’re never going to outperform a given level of risk.
Joel: So how do you increase or raise that alpha?
Kyle: Where you really can add some value is in the actual active management. You know, we talk about asset allocation and how getting the allocation right can really reduce your risk. It can also add some value over and above a particular benchmark. But where we really can drive some alpha is in that active allocation of our individual funds.
And what we find is that there are managers out there who may be benchmarked to a particular index – say the S&P 500, but they’re not trying to take the risk of the S&P 500. They’re actually much happier to take some percentage of the risk of the S&P 500, and where they’re able to add alpha is in outperforming that level of risk.
Joel: So they could get average returns for less-than-average risk.
Kyle: Yeah. That’s really the key here in alpha is we’re happy with average returns. That’s what we would expect from an index. What we’re not happy with is taking average risk to get there. And so by purely being focused on returns and never looking at the risk side of the equation, it’s easy to think that indexing is really the be-all-end-all. But when you bring into it the fact that you’ve got to take average risk to get there, it just isn’t what it’s made out to be. You know, we really want to be below average with risk.
Joel: So, for investors who are interested, is looking at alpha by itself useful?
Kyle: Yeah. It can be. As long as they understand what it is they’re looking at and that’s not a measure of their return. It’s a measure of their return relative to their level of risk. And that’s why we talked about beta first. That’s always the first conversation we have with clients is making sure that we’ve got their level of risk correct because returns are a secondary thing. It’s a function of risk. You don’t get returns without taking some measure of risk.
Joel: So alpha shows us the value added at a particular level of risk.
Kyle: Yeah. The key really is that level of risk. And that’s really what we’re targeting for clients. Again, not just returns, but what kind of risk a client is comfortable with so that as the market vacillates, as things bounce around, the client is comfortable with the performance of the portfolio – understanding that things go up and down and understanding what kind of expectation they should have of their portfolio as that occurs. And then we get into the alpha. And then we talk about what kind of value we can add at that level of risk.
Kyle Tetting is director of research at Landaas & Company.
Joel Dresang is vice president-communications at Landaas & Company.
Money Talk Video by Peter May
(initially posted May 16, 2014)
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Learn more Watch Kyle Tetting in Beta: Learning how risky an investment might be and in Talking Money: Measuring risk and reward as well as in Talking Money: Modern Portfolio Theory and in Correlation: A tool for balancing investment assets. Also, learn about the Efficient Frontier in balanced investing from Steve Giles