Alpha is a measure of a fund's over- or under-performance by comparison to its benchmark. It represents the return of the fund when the benchmark is assumed to have a return of zero, and thus indicates the extra value that the manager's activities have contributed: if the Alpha is 5, the fund has outperformed its benchmark by 5%, and the greater the Alpha, the greater the outperformance.
A further aspect of Alpha emerges when it is taken in conjunction with Beta. Assuming that a strong R-Squared correlation exists, the Beta will show how volatile the fund is compared to its benchmark, and thus indicate how much extra risk the manager has taken on in order to get that high-Alpha performance. Negative Alpha in conjunction with 1+ Beta is an indication of poor performance: managers are subjecting funds to volatility that is higher than the benchmark, while achieving returns that are lower than the benchmark attained. So, if Alpha indicates better/worse performance compared with the index, Beta shows higher/lower risk.
Worked Example: The impact of high Alphas and low Betas in differing market conditions
Alpha can be viewed as a measure of the performance a manager adds to a fund in excess of the returns that the market would have produced anyway. In a rising market, higher Alphas can identify those funds that will take greater advantage in conditions where some managers may be content just to sit back and settle for the systemic gains.
By contrast, in a falling market, a more defensive position is often sought. Funds with lower Betas – below 1.0 – will move downwards at a proportionately slower rate than that of the market, and so mitigate loss. By the same token, the lower Beta funds will participate in upside gains at a similarly diminished rate.
This exercise examines what happens to these two types of fund in two discrete calendar years that exhibited very different market conditions. (And there is no reason to choose these particular funds, other than that they illustrate our example quite strongly.)
Bear Market: 28 February 2001 to 28 February 2002
The following table shows our key ratios from the period for two very dissimilar funds; their IA sector is also included.
Table 20. Ratios table (from 28 Feb 2001 to 28 Feb 2002) against benchmark "UT UK All Companies" (risk free rate at 3.5%) of UT UK All Companies Sector from Unit Trust/OEIC universe
| Name |
Alpha |
Beta |
R-Squared |
| Cavendish Opportunities TR |
13.62 |
1.63 |
0.84 |
| Sector: UT UK All Cos TR |
0 |
1 |
0.84 |
| Morgan Stanley UK Equity TR |
-2.35 |
0.61 |
1 |
In both cases, there is a strong r-squared correlation between the funds and the sector benchmark, which means that we can place some reliance in the other ratios. There is a marked difference in their Betas: for every 1 point fall in the benchmark, the Cavendish offering is set to drop 1.63 points, whereas Morgan Stanley's fund would lose only 0.61 – more than a full point's difference. So Morgan Stanley's investors should be carrying less than two thirds of the benchmark's downside. To see how this translates into performance, we have a further table:
Table 21. Total return performance (from 28 Feb 2001 to 28 Feb 2002) of UT UK All Companies Sector from Unit Trust/OEIC universe
| Name |
Period Performance |
Sector Ranking (of 235) |
| Morgan Stanley UK Equity TR |
-10.06 |
47 |
| Cavendish Opportunities TR |
-11.38 |
71 |
| Sector: UT UK All Cos TR |
-12.97 |
113 |
Very few funds have prospered in this Bear market (only 7 out of the sector's 235 avoided a loss), with the group as a whole dropping almost 13 points. But the Cavendish fund hasn't been as heavily punished as its Beta would suggest, and Morgan Stanley's hasn't got off as lightly. A clue to this lies in the corresponding Alphas: the Cavendish high Alpha is evidence of very active management to mitigate the systemic forces, while Morgan Stanley's negative ratio indicates that they may not have intervened sufficiently to make the most of their advantageous Beta.
The figures do, though, broadly bear out the impact of a lower Beta in this market. Morgan Stanley's fund has performed better than the Cavendish, and was comfortably ahead in the sector rankings. For the bad times, so far, so good. But what happens to these clearly different management styles when conditions improve? This brings us to our next section.
Signs of recovery: 28 February 2003 to 28 February 2004
The following table re-examines the Alphas and Betas to see whether the disparity between the approach of the two fund managers was maintained.
Table 22. Ratios table (from 28 Feb 2003 to 28 Feb 2004) against benchmark "UT UK All Companies" (risk free rate at 3.5%) of UT UK All Companies Sector from Unit Trust/OEIC universe
| Name |
Alpha |
Beta |
R-Squared |
| Cavendish Opportunities TR |
10.69 |
1.73 |
0.84 |
| Sector: UT UK All Cos TR |
0 |
1 |
1 |
| Morgan Stanley UK Equity TR |
-1.65 |
0.98 |
0.92 |
Morgan Stanley have raised their Beta, so the fund will track any sector gains more closely than before. Also, they have increased the Alpha but, despite this, they are still not generating a positive return over the benchmark; this speaks of a passive tracking strategy which lets the Beta proximity produce whatever gains the market has to offer. Cavendish have increased their Beta – accelerating participation in systemic returns – while dropping back on the level of positive Alpha. The Alpha level still suggests a very actively managed portfolio, but with a reduced degree of intervention so as to ride the rising market.
With our final table, we can see again what effect this had on performance.
Table 23. Total return performance (from 28 Feb 2003 to 28 Feb 2004) of UT UK All Companies Sector from Unit Trust/OEIC universe
| Name |
Period Performance |
Sector Ranking (of 303) |
| Cavendish Opportunities TR |
82.51 |
2 |
| Morgan Stanley UK Equity TR |
35.55 |
145 |
| Sector: UT UK All Cos TR |
39.7 |
99 |
It's clear that, unlike the marginal differences in return from our previous example, the outcomes here are dramatically at odds. The still-conservative Beta, in conjunction with negative Alpha, has Morgan Stanley slipping considerably down the rankings, while failing even to match the return that the sector average produced. The Cavendish approach, in stark contrast, has lifted the fund to the sector's no. 2 slot, and rewarded its investors with an 82% gain in the space of a year.
In summary, then, we have seen how a low Beta can provide a defensive home, mitigating the losses that could all too easily be incurred in a falling market. Conversely, this type of fund struggles when markets are recovering, and it is the high Alpha funds that take maximum advantage in an upturn.
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