What is Alpha? And Why Should You Care?

Emma Wall: Hello and welcome to the Morningstar Series 'Ask the Expert'. I'm Emma Wall and I'm joined today by Edward Smith, Asset Allocation Strategist for Rathbone.

Hi, Edward.

Edward Smith: Hi there.

Wall: So today we're going to take a term that a lot of people have heard of, but you think they are not quite understanding properly and that’s alpha. So what is alpha?

Smith: So to put the theory very simply, we've got alpha, we've got beta. So beta is the element of investment return or portfolio returns that can be explained and particularly can be explained by market risk by exposure to market. Alpha is the residual, it's the unexplained element, it’s the dark matter. Now it's sort of commonly thought of that alpha represents some sort of fund manager, stock picking, secret source. They should be able to achieve, because it's got nothing to do with the market. They should be able to achieve in all market environments.

Now that’s perhaps a bit of an oversimplification. I think investors need to ask what if beta is about more than just exposure to a certain market. What if we broaden out that definition of beta to include various other risk factors. Those risk factors could be things like star biases like growth, quality, value. It could be about leverage, another factor might be the size of the companies invested in.

Now if we think of it like that and take it back to performance measurement. The alpha when you have all of these different kinds of betas, maybe a little smaller. But that doesn’t necessarily mean that the fund managers have less skill by any means. It just means that investors need to think about which skills they want to pay off for at the given moment in the cycle.

It takes a lot of skill for a fund manager to consistently maintain exposures to a certain type of beta, let's say quality beta. Takes a lot of skill for a fund manager to allocate between different types of risk factors in different markets. Now all of that is worth paying up for, but it's not necessarily this alpha that can win out, it's going to always outperform in all market environments.

Wall: That’s an important point to make. Because misunderstanding these definitions means as you say investors risk buying a particular fund and thinking well this fund manager has done particularly well for the last two three years which is quite different to way that the underlying market has returned therefore. Whatever the market does this manager will outperform?

Smith: That’s absolutely right, so in the traditional very simple version of beta and alpha it may look like these guys had generated alpha for three or four years you'll be able to see that all the time. It's great. That’s what alpha is, but actually what if it he is just a great quality fund manager for example, has a quality bias companies that have good balance sheets, can grow their earnings consistently. He's just great at picking those sorts of companies and it's that type of beta that risk factor which he is getting exposure to that he is winning out. It might still be worth investing with him if that’s going to continue. But it's those sort of questions that you need to think about.

Wall: Let's put that into practice then. One of the particular point in the market cycle in the U.K. we've had a very good run from the credit crisis. But the last couple of years have been quite sticky flat. In particular for large caps. So bearing what you've just said in mind. What sort of style bias which indeed is still beta should people be going for at this point in the market cycle.

Smith: Well, I use the example of quality a moment ago and I think that’s something that we've seen consistently outperform for a number of years. There is a lot of earnings uncertainty in the world today. We think investors are going to continue to pay up for feasible earnings those companies with a track record of growing their earnings, earning stability some sort of reliability. So again we think those quality betas, those growth betas are going to win out.

Wall: Edward thank you very much.

Smith: Pleasure.

Wall: This is Emma Wall from Morningstar. Thank you for watching.