When it comes to portfolio and performance analysis it is essential that investors understand the key performance metrics. Two important measures which are often used in fund or portfolio analysis are alpha and beta. Both measures are derived from the Capital Asset Pricing Model (CAPM), which was introduced in the early- to mid-1960s and are calculated based on the past performance of a portfolio. Despite these similarities, alpha and beta offer different insights into the risk and return characteristics of a portfolio.
Beta: A Measure of Market Risk (Systematic Risk)
Beta measures a portfolios sensitivity to market movements, the so-called systematic risk, indicating how much a fund is expected to move in relation to the broader market (often represented by an index such as the S&P 500). A beta of 1 means that it can be expected that the portfolio moves in sync with the market. If a portfolio has a beta greater than 1, it tends to be more volatile than the market, meaning it may see greater price swings.
What does this mean in practice? If a portfolio has a beta of 1.2, it may rise 12% if the underlying market rises 10%, but it may also fall more sharply during a market downturn. Conversely, a beta less than 1 suggests that the portfolio is less volatile than the underlying market.
That said, a portfolio with a high beta might be preferred by investors who are looking for high returns regardless of the risk, but is most likely avoided by investors who are seeking steady returns with a low risk.
Alpha: A Measure of Excess Return
Alpha represents the excess return a portfolio has generated from the decisions taken by the portfolio manager compared to its expected performance based on its beta. It shows how well the portfolio manager has done in outperforming the market, adjusted for the level of risk taken compared to the market. This means alpha can also be seen as a measure for unsystematic risk (manager risk). The results for alpha can be positive or negative.
For the example above, if a portfolio has a beta of 1.2, investors might expect it to outperform the market by 20% in good times due to its higher risk. If the actual return of the portfolio from the example above is 17% (instead of the expected 12%), the portfolio has a positive alpha of 5.0, which is signaling strong management or effective stock picking skills of the portfolio manager. On the other hand, a negative alpha shows that the portfolio has underperformed when taking its respective (higher or lower) risk profile compared to the market into account.
As a result, it can be considered that a high alpha is always good. That said, alpha (and beta) are only taking the past performance into account, which means these measures do not predict the future performance of a portfolio.
This article is for information purposes only and does not constitute any investment advice.
The views expressed are the views of the author, not necessarily those of LSEG Lipper or LSEG.
