Issue: November/December 2005

What alpha means for your investments

Alpha? Beta? - is the latest investment jargon sounding a bit like Greek to you? What do these words actually mean in the investment world? Essentially, they are used to describe the nature of the return on an investment, and are important for measuring the skill of an investment manager.

Portfolio managers globally have managed money on behalf of investors with the objective of providing a return. To achieve this, managers have invested in a variety of assets including equities, bonds, cash and property. The return that an investor receives consists of two very separate parts. A portion of the return is due simply to the return delivered by the asset class, and is called the market return or "beta". This portion of the return is beyond the control of the portfolio manager and s/he has no ability to influence the outcome, irrespective of the manager's level of skill.

The remaining portion of the investor's return is the extra return added by the manager and is known as "alpha". This second portion is all about skill and has everything to do with making the right investment choices.

To illustrate below: If an investor had invested R100 in Portfolio A at the end of September 2004 his investment would be worth R143 by September 2005 - a return of 43%. Over this period the equity market, as represented by the All Share Index, generated a 39% return. Thus of the total return of 43%, 4% represents the alpha generated by the portfolio manager. Simply put, any extra return above the market return is referred to as alpha.

alpha graph

Why has alpha become so important

It has always been important for asset managers to demonstrate skill, but never so important as now. But why alpha generation became the mantra of the investment world? A number of reasons came to mind:

  • Most investment professionals would agree that future market returns are likely to be low. This is due to global disinflation leading to low yields in most developed countries as well as South Africa. Alpha is significantly more important in a low return environment. For example, a good manager might be able to consistently add, say, 4% above the market through sustainable investment skill. If the market return is say 40%, this 4% represents some 10% of the market return and is arguably not particularly important. But if the market return is say 8%, then the manager alpha is 50% of the market return, a very significant number.

  • External issues - such as a pension fund deficits - are putting pressure on funds to deliver higher returns to meet future liabilities. It is fair to say that the global savings industry is in disarray and the low projected future returns are only serving to make matters worse. Given that the financial markets on their own are unlikely to provide the required returns to restore the industry to full health, it is not surprising that alpha generation skills are in high demand.

  • Technological advances have made alpha measurement easier.

    Technological advances have also meant that risk, as well as alpha, can now be more accurately measured. Increased volatility (or risk) in a portfolio may result in higher returns, but it is important that this extra return is not simply the reward for the extra risk taken. In other words, the risk adjusted return must be better than the market return in order to justify the extra risk taken. It is now possible to measure more precisely whether extra returns have been added by deploying true skill, or merely by taking a higher risk. It is no longer good enough to ride on the back of a frothy market or just "go up the risk curve" to generate extra returns. Today, managers are required to optimise returns to beat the market, and it is this alpha generation that has become the mark of a good manager.