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 All investment returns can be seen as the culmination of the market return (Beta) and excess returns (Alpha). The rise of index funds has shown that achieving Beta market exposure is inexpensive and easily achievable through index mutual funds and exchange-traded funds (ETFs).
Institutional investors have recognized that in order to maximize returns, minimize costs and manage the risks of their portfolios, manager performance (Alpha) can be separated from Beta using straightforward tools and analytical techniques. The academic rigor associated with this process has helped uncover an entire new set of asset classes: Alternative Beta.
Alternative Beta and Alpha separation have proven to be tremendous tools in the hands of the world's largest institutions, but implementing these strategies on a smaller scale presents substantial analytical and implementation challenges.
The rise of synthetic hedge fund products and low-cost ETFs has made the fine-tuning of portfolio exposure through these two techniques easier than ever before, and accessible to a broad range of investors.
Understanding Returns: Alpha Vs. Beta
There are moments in history when the science of investing takes a major step forward. The birth of the Capital Assets Pricing Model (CAPM) was one of them; the dawn of index funds was another.
Today, another investing revolution is afoot: Alpha/Beta separation. No matter what's in your portfolio, it can be described in certain universal ways, like risk and reward. Perhaps the most critical of these concepts is that of Alpha and Beta. Simply put, Beta is the risk/reward of your portfolio that is explained just by being in a particular market. Alpha is excess return—that elusive edge that lets you (or your investment manager) beat the market.
For most investors, Alpha and Beta are inseparable. When you buy an active mutual fund, for instance, you're buying a lot of Beta and a little bit of Alpha.
But the most sophisticated investors are now decoupling the two, separating their decisions about Alpha from their decisions about Beta. This new investing technique allows investors to gain increased control over their asset allocation strategies, control costs and—most importantly—maximize returns.
Let's look at the constituent parts.
Beta: The Market
For many investors, the most important investment decision they will ever make is simply to invest in the market. Study after study shows that our most basic asset allocation decisions determine the bulk of our portfolios' returns. We may spend countless hours reading Barron's, trying to figure out how to beat the market. But the most important thing from a returns perspective is making sure that we are in the market—getting market-level returns for market-level risks, preferably at low cost.
Fortunately, market returns—aka Beta—are both widely available and wonderfully cheap. Mass-market retail products such as index mutual funds and exchange-traded funds reliably deliver market returns in many traditional asset classes at extremely low costs. State Street Global Advisors' S&P 500 SPDR ETF (NYSE Arca: SPY), for example, trades millions of shares a day, has a net expense ratio just shy of 0.10 percent and has exhibited virtually no tracking error to its underlying index. Not a bad deal.
Derivatives offer another efficient tool for accessing index-level returns. Both futures and options allow investors to gain exposure to most of the world's markets with minimal cost and tremendous flexibility.
As we'll explain, new index-based investment products are even opening up alternative asset categories, like hedge funds, to Beta approaches.
Regardless of the structure or asset class, however, all of these index-based vehicles have one thing in common: They provide pure Beta. In other words, their risks and returns can be explained nearly entirely by the movement of the market they track.
These index-based strategies provide investors with great ways to "buy the market" at low cost and with enhanced liquidity.
Alpha: The Elusive Goal
What about "beating the market?"
For most of the history of investing, the role of the advisor, investment manager or consultant has been to do better than the market. In the simplest terms, that's Alpha: the portion of a portfolio's return that is the result of a manager's skill, and not the return of the market.
Taken this way, determining a portfolio's returns is simple:
Alpha
+ Beta
– Costs
________________
Total Real Return
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