Alpha: Can You Beat The Market?
For many investors one of the lingering uncertainties is whether or not we are better-off pursuing an active investment strategy, or whether simply placing funds into a professionally-managed or low-cost index fund, would yield higher returns.
In this issue of Bullseye Insights we take a closer look at a key measure of investing performance - Alpha - and whether investors are wasting their time fighting against the odds by attempting to beat the market.
So what is Alpha?
Alpha is a measure used by professional investors to quantify an ability to beat the market - or at least achieve better returns than the market as a whole. Remember: even in a bear market, it is still an achievement to beat the market.
Alpha is commonly represented as a percentage, with either a positive or negative value. As such, an alpha of zero indicates that an investment's performance is tracking perfectly with the comparative benchmark or index chosen, and that the investor has not added (or lost) any value when compared to the broader market performance.
An investment that outperforms the 'market' has a positive alpha value. Underperformance versus the 'market' results in a negative alpha value. For the purposes of an Alpha calculation, the 'market' is represented by a relevant market benchmark or index, such as the FTSE100.
For example, if the benchmark return is 5% over a given time horizon and your investment returns 8% over the same period, the Alpha would be +3% (i.e. 8% - 5% = 3%).
If the same investment returned only 4%, when compared to the same benchmark over the same time horizon, it would have a negative Alpha of -1% (i.e. 4% - 5% = -1%).
Alpha is a simple and effective way for an investor to measure relative performance, and goes to the heart of answering that very important question: am I adding value, or simply wasting my time?
Did you know?
Legendary investor Warren Buffet believes most investors would achieve better returns by investing in an index fund as opposed to trying to beat the market. He believes that any active return fund managers make will eventually be eroded by fees. Research from S&P and Dow Jones indices supports Buffet’s thinking. Data revealed that active investors who outperform against a benchmark over a one-year period have a less than 50% chance of outperforming it again by the same rate in the second year. The study also found that, even if investors had a successful three-year record of generating active returns, they underperformed the benchmark in the following three years.
At Bullseye we believe strongly that intelligent investing requires active monitoring of performance, and basing trading decisions on facts, using tried and tested technical and performance-related indicators to inform, rather than listening to self-appointed social media experts or chat forum trolls.
That is why we view Alpha as a key indicator for all investors no matter whether you are novice or seasoned pro. It is also why we have built functionality into our platform to allow users to measure their performance over varying time horizons against established international market indices - such as the FTSE100, S&P500, EuroStoxx50, Nifty50, HangSeng and many more.
Things to consider
We are all here because we believe our investments will deliver a positive return beyond the level produced from adopting a passive investing strategy.
While Alpha is seen as the holy grail of investing, particularly for those professional investors who build their reputation on an ability to consistently deliver Alpha, like many things it is only useful when applied in the correct context.
There are two seemingly obvious, but very important considerations to take into account when analysing Alpha.
1) Keep it relevant
A basic calculation of Alpha subtracts the total return of an investment from a comparable benchmark in its category. Therefore, for useful comparisons to be made it is important that you get the context correct and use an appropriate market benchmark or index.
Appropriate can mean different things to different people - but generally this means using a comparative benchmark that is the same or similar to the market or sector of the investment being monitored.
You know what they say about comparing apples and oranges!
Other than context, the second critical dimension of any alpha calculation is time. Over what time horizon are you comparing performance?
Although Warren Buffet may believe that most investors would achieve better returns by investing in an index fund, as opposed to trying to beat the market, he also famously said:
"The stock market is a device for transferring money from the impatient to the patient."
Don't lose faith if your Alpha is negative in the short-term. Similarly, it does not mean you are an investing super-deity if you manage to return a positive Alpha over the same time period.
Take a balanced approach and overlay your unique circumstances and wider market conditions to the result. Alpha is one of the key tools at your disposal to make informed investing decisions, but not the be-all-and-end-all.