Alpha and beta

You will often hear of an investment strategy or manager’s ability (or at least aim) to deliver “alpha”. This is a measure of performance which describes delivering returns in excess of broad market rises over a certain period or “beating the market”.

Alpha will be measured against a market index or benchmark taken as a proxy for the market’s movement as a whole, so if the FTSE100 were to have risen 5% and an investment strategy or fund benchmarked against it delivered 10% in a year it will have earned higher alpha than the market (the baseline is zero, meaning that there was nothing to separate the performance of the strategy or fund from the benchmark it is gauged against).

Alpha is important as it indicates how much value a portfolio or fund manager adds (or, in unfortunate circumstances, subtracts) relative to the investment returns which might be expected. It is therefore an indicator of whether they represent good value for money in terms of gains. If you are paying higher fees for active management but don’t achieve alpha relative to a benchmark index, then it could be argued that you may just as well have bought a cheaper index-tracking or Exchange-Traded Fund.

Beta, meanwhile, measures how sensitive a stock is to movements in the broader market given its historical behaviour. One with a beta of 1.0 moves exactly in line with the market, whereas one with a beta higher has been more volatile than the market. If a FTSE100 stock has a beta of 1.5, we would expect it to rise by 15% if the FTSE rises 10% or, conversely, to fall by 15% if the FTSE were to shed 10%.

In simple terms, higher beta means higher volatility, and the concept can help investors to choose investments which match their tolerance for risk. So, if you were the kind of investor who is made uncomfortable by stocks that tend to swing more wildly than the broad market, then you would look for those which track the index closely and a beta as close as possible to 1.0. On the flipside, those who are more sanguine about significant price movements could seek out higher beta stocks to, taking on additional risk for the promise of greater returns.