Alpha,’s all Greek, but don’t fall for it

While 'beta' is a useful guage of investmnet risk, 'alpha' is no more than City art dressed up as science, says Tim Bennett. Here, he explains why you shouldn't be taken in.

Alpha' and beta' are two widely used investment terms. But do they actually mean anything useful? Or are they just yet more sales jargon used by the financial industry to pull the wool over your eyes?

What beta measures

We'll start with beta, because it is the basis for alpha. Beta purports to measure how sensitive a fund or stock is to movements in the wider market. Take three different stocks: drugs giant GlaxoSmithKline (GSK) has a beta of about 0.5; technology giant Apple has a beta close to one; while miner Rio Tinto has a beta of about two (figures from

These figures tell you that when the British stockmarket moves by 10%, GSK would typically move by about half that (5%). Apple, with the same beta as the US Nasdaq index, would be expected to rise and fall in line with it. Rio Tinto's beta of two suggests that when the UK stockmarket rises by 10%, Rio should typically rise by 20% (twice the distance), and vice versa if the market falls. So stocks with a beta below one have low volatility (defensive') and those with a beta above one are more volatile (cyclical').

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Some say that beta indicates how a portfolio will perform under given conditions. So you'd buy high-beta stocks when the market is rising, and low-beta stocks when it is falling. Also, a high-beta portfolio will be more volatile than a low-beta one. Sounds useful. But there are a couple of problems.

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If the market crashes, you will be caught out whether you are in high- or low-beta stocks. You might lose a bit less in low-beta stocks, but ideally you don't want to lose anything at all. So beta won't help you here.

Next, beta is historic. Without going into the maths (regression analysis'), beta is calculated by comparing how a stock has behaved compared to the market over a given period of time. This could be a year, two years, or longer, depending on who is publishing the number. That's why the beta for a given stock varies between sources. But as we're always reminded, the past is no guide to the future. Long-existing correlations can break down. So relying on it is risky.

What alpha measures

This wouldn't matter except that fund managers happily use beta to calculate alpha', which is more of a sales tool than a useful indicator. Fund managers want to convince you that they generate bigger returns and more alpha' than anyone else, and so are worth paying high fees for. Alpha is the excess total return from a portfolio that is not explained by beta: it's the money made due to the manager's skill, rather than just the market going up.

But how do you work out alpha? This is where the capital asset pricing model (CAPM) comes in. CAPM has been the basis for forecasting market returns in the fund-management industry for decades. It asks three questions and combines the answers in one number. Firstly, what return can an investor earn from a largely risk-free asset, such as UK gilts (government IOUs)? Secondly, what extra return (risk premium') should you demand for buying risky shares, instead of gilts? Thirdly, how should you adjust that for stock-specific risk, or beta?

So say the average expected annual return on 10-year gilts is 2%; the extra return you want for buying shares is 6%; and the beta of the stock you want to buy is two. CAPM says you should expect a total return of 2%, plus the 6% risk premium, adjusted by beta. That's 2% + (6% x 2), or 14%. If the stock returns 20% instead, that extra 6% is alpha. It's the bit of return that's due to the manager's skill.

The trouble here is that, clearly, CAPM is highly subjective. It is based on a guesstimate' (expected gilt yields), adjusted for a total guess (the equity risk premium), multiplied by an out-of-date beta. It's art dressed up as City science, often to justify a performance bonus. Moreover, even if alpha' had any scientific justification behind it, finding a fund manager who can generate it consistently would be nigh-on impossible.

Rather than waste your time trying to find such a manager, you are better off either tracking your chosen markets with a cheap exchange-traded fund, or finding a fund or investment trust manager with reasonable charges who has a consistent strategy that chimes with your own views.

Anyone who uses options will come across three other important Greek letters delta, gamma and theta. If you are brand new to options, take a look at my introductory video on the topic: What are options and covered warrants?

More Greek for options traders

: delta measures volatility. Say an option to buy 1,000 Tesco shares within the next three months has a 0.5 delta. If Tesco's price moves by 10%, the option premium should rise by around half that (5%). The higher the delta, the greater the volatility.

: gamma shows how rapidly volatility (delta) is changing. High gamma options are the riskiest.

: theta measures how rapidly an option is running out of time value. Like an insurance contract, options have a fixed expiry date if they remain unused (are unexercised'). Say you buy a three-month option that will last 90 days. On day one you will lose 1/90th of its remaining time value. That reduces the premium someone else will pay for it. On day two you lose 1/89th, on day three 1/88th and so on. The longer you hold an option unexercised, the less it is worth to someone else.

Tim graduated with a history degree from Cambridge University in 1989 and, after a year of travelling, joined the financial services firm Ernst and Young in 1990, qualifying as a chartered accountant in 1994.

He then moved into financial markets training, designing and running a variety of courses at graduate level and beyond for a range of organisations including the Securities and Investment Institute and UBS. He joined MoneyWeek in 2007.