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What's Behind Your Fund Returns?

Beta may be boring, but it provides the majority of funds' returns.

Michael Rawson, CFA 18 August, 2015 | 16:45
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During the past two decades, the share of passively managed equity fund assets has risen. While some lament that passive investors have consigned themselves to merely average returns, the truth is that the market average has been pretty good. The excess return on U.S. stocks has been about 6.1% annualized since 1926. The market return is the baseline upon which we can judge the performance of any U.S.-stock fund. In fact, most of the movement of our funds can be explained by exposure to a broad market index, otherwise known as market beta. Any return that an active portfolio manager can deliver in excess of the return from beta is alpha.

For most funds, beta is the largest source of return. The expectation for return beyond that which can be obtained cheaply through beta could justify the higher fees that active managers charge. But from January 2011 through December 2014, beta sources provided 104% of the return to the average active U.S. equity fund. Even among the 39% of the active fund share classes that managed to produce non-negative alpha, beta sources contributed 89% of the return.

The traditional market beta from the capital asset pricing model (CAPM) indicates the extent to which a portfolio is exposed to the market. The portfolio return that is related to beta represents compensation for bearing market risk. But there are other betas. Many portfolio managers have found success by buying small-cap stocks, value stocks, high-quality stocks, and those with strong momentum. It turns out that these characteristics of individual stocks are systematically related to the risk/return profile of an entire portfolio.

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About Author

Michael Rawson, CFA  Michael Rawson, CFA is an ETF Analyst with Morningstar.

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