Defining “Alpha” and “Beta”.

Investment jargon is often “Greek” to the average investor and Greek they are!  While we do not definitively know why the investment industry adopted all these Greek terms (specifically to describe risk), a possible reason could be that the Greeks were the first to work systematically on the sciences.  Two of the most used terms are “alpha” (α) and “beta” (ß).

Investment portfolios deliver their returns to investors in two ways: the first element comprises the return on the market as a whole.  This can be understood as the economic reward for taking on the risk of the market.  In the case of equity portfolios, the risk of the market as a whole is known as “beta”.  The compensation for taking this risk is the return on the market as a whole (i.e. the All Share Index return) minus the return on a “risk-free” asset (cash).  In investment language, this extra return is known as the “market risk premium”. 

The second element of returns consists of the extra returns on selections of individual risky securities or shares.  In a given market, these extra returns can be either positive or negative.  The selection of holdings of securities that promise such extra return is called “active” investment, and the return generated by these “active bets” is described in investment circles as “alpha” or excess return.  By definition, the alpha of the market as a whole is zero.  So it is easily understood that not all investors can earn returns in excess of those for the market.  Only about half of all such returns can be positive in any given period. 

Equity portfolios can be viewed as a hybrid of two effects: a replication of the market as a whole (as represented by an index or benchmark), which seeks to capture the market risk premium, and a series of “active” stock selections, which seek to deliver extra returns above those earned by the index.  Index replication or tracking, often called “passive investing” is a low-cost investment strategy (in SA, it typically costs a modest 0.5% per annum or lower) whereas active strategies require extra labour, information and transaction costs to research and implement active bets, and include the manager’s profit margin on these extra costs.

At Bovest we follow the hybrid approach, i.e. a large allocation is made to beta strategies where fees are typically lower while the rest of the portfolio is allocated to specialist managers that follow an active strategy in a quest to beat the average market returns.

Esmarie Strydom B.Com (Hons)

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