Understanding Alpha and Beta in Investing
Words matter. Use seemingly fancy names such as “alpha” and “beta,” and investing looks and feels super complicated. Strip those terms down to what they’re meant to measure — performance and risk — and, suddenly, alpha versus beta investing makes much more sense.
Introduction to alpha and beta investing
The investment arm of BMO Bank put it best: “Alpha is often used to identify investment skill, while beta is used to measure the relative risk, or volatility, of an investment or portfolio.” You might hear investors say they’re seeking alpha or that this or that fund manager generates alpha. This just means they’re trying to win or currently winning. Alpha measures investment performance against a benchmark after taking into account that investment’s risk level, as measured by beta.
Alpha in investing
To best understand alpha, think about one of the most widely used stock market benchmarks, the S&P 500 Index, which measures the performance of 500 large domestic companies. If a portfolio — yours, Warren Buffett’s or a fund manager’s — beats the S&P 500, that portfolio has found alpha. Holding volatility constant, if this portfolio generates the same return as the S&P 500, it has an alpha of zero. If the S&P 500 returned 25% in a given year and this portfolio produced 40% upside, the portfolio’s alpha would be 15%.
There’s an important relationship between alpha and beta that affects this illustration, which we cover in a moment.
How to calculate alpha
You don’t need fancy formulas to calculate alpha. Referring to the above example, it’s easiest for everyday investors to use this formula:
Alpha = investment return – benchmark return
An actively managed exchange-traded fund (ETF) or mutual fund, for example, that beats the S&P 500 has produced alpha versus the benchmark. But the S&P 500 is not the only benchmark by which investors measure alpha. The benchmark for a small-cap stock fund, for example, might be the Russell 2000 index, an index that measures the performance of small domestic companies. Bond funds will measure their performance against various bond indexes.
Examples of alpha
Alpha is the holy grail for fund managers. Some funds passively mimic the returns of broad stock market indexes by holding the exact same stocks in the exact same concentrations as the index. This approach results in an alpha of zero. However, some funds take a benchmark and only select stocks from it that meet certain criteria. They use an active stock selection strategy with the goal of beating the benchmark. This is where we get the phrase, “seeking alpha.” Thousands of active funds attempted to outperform their benchmarks in 2023. Some succeeded. Some did not.
Consider two similar ETFs: the JPMorgan Active Growth ETF (JGRO) and the Fidelity Blue Chip Growth ETF (FBCG). Both ETFs are actively managed, have about $1 billion in net assets, and generally invest in large- and mid-cap stocks. However, they each pick and choose holdings using their criteria. Both are benchmarked against the Russell 1000 Growth Index, an index that measures the performance of 1,000 large-cap companies, which posted a total return of 42.7% in 2023. In 2023, JGRO returned 37.7%, while FBCG returned 58%. Relative to the Russell 1000 Growth Index, FBCG generated alpha. Even though it was up on the year, JGRO did not.
Beta in investing
While alpha focuses on relative performance, beta measures risk, specifically how volatile an investment is compared to a market benchmark. A benchmark’s beta is always 1.0. An investment with a beta of 2.0 is twice as volatile as the benchmark, while an investment with a beta of 0.75 is 25% less volatile. This is where the relationship between alpha and beta comes in. A fund manager might generate impressive alpha but, if they’re doing it alongside an outsized beta, they might not be delivering returns commensurate with the level of risk investors in their fund are taking on.
How to calculate beta
You need heavy math and historical data to calculate beta using the following formula, outlined by financial services company CMC Markets:
Beta = Covariance (Rs, RI) / Variance (RI)
Where:
Rs is the return of the stock
RI is the return of the index
Covariance is how the stock’s returns vary from market returns
Variance is the dispersion of market returns
To do this, you need to first calculate covariance, which, in and of itself, is daunting. Thankfully, you can spare yourself the math because most brokerage platforms and investing sites include beta as one of the metrics in their detailed stock quotes.
Examples of beta
Going back to the alpha-beta relationship, let’s consider individual stocks. At the end of 2023, Tesla (TSLA) had a five-year beta of 2.3. Apple’s (AAPL) beta was just 1.3. TSLA stock was up nearly 102% in 2023, crushing the S&P 500 and AAPL’s impressive, also S&P 500-beating total return of approximately 49%. All else equal, we can say TSLA was 2.3 times more volatile than the market, while AAPL was 1.3 times more volatile. Considering ETFs, the above-mentioned FBCG had a beta of 1.3 at the end of 2023, alongside its 58% return. Meanwhile, one of the more popular active ETFs, the ARK Innovation ETF (ARKK), returned just under 69% in 2023 with a beta of 1.7.
Comparison table of alpha and beta features
Which is better for you: alpha or beta investing?
Investing for alpha versus beta, or both, really depends on your investment profile and preferences. If you’re the type of investor who doesn’t like volatility, you might lean toward holdings like Apple or Fidelity’s Blue Chip Growth ETF where you’ll get alpha at a lower beta. If you’re more aggressive, you might favor holdings like Tesla and ARK’s Innovation ETF where — in recent history — higher risk brings higher reward. Or you might opt for a mix of both. One size definitely doesn’t fit all. All of this said, the downside of alpha and beta in investing is that both measure past performance, which might not hold going forward. Alpha requires a track record for greater accuracy, whereas beta tends to better assess short-term risk given that the volatility of an asset can change on a dime.
Frequently asked questions (FAQs)
How is beta expressed? Beta is expressed as a decimal using the formula shown above. Morningstar calculates beta by comparing a fund’s excess return over Treasury bills to the market’s excess return over Treasury bills, so a beta of 1.10 shows that the fund has performed 10% better than its benchmark index in up markets and 10% worse in down markets, assuming all other factors remain constant.
How do you calculate alpha? The commonly accepted formula for calculating alpha is:
Alpha = Annualized security return – risk-free rate – beta * (annualized benchmark return – risk-free rate) * 100
To calculate alpha, Morningstar uses a slightly different approach: “Morningstar deducts the risk-free return from the total return of both the portfolio and the benchmark index. Thus, the alpha figures shown by Morningstar may be lower than those published elsewhere.”
What are smart beta ETFs? Unlike passive index ETFs, smart beta ETFs construct their portfolios not based on the market capitalization of companies in an index but on other factors, including business metrics and volatility. Some smart beta ETFs weigh all companies in an index, such as the S&P 500, equally, rather than by market cap. These ETFs are known as equal-weight ETFs.
What is the main difference between alpha and beta? The main difference is that alpha measures performance, while beta measures risk.
Analyst comment
This news provides an explanation of alpha and beta in investing, with examples and calculations. It is neutral news that helps investors understand these concepts. Understanding alpha and beta can help investors assess performance and risk in their portfolios.
