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What are alpha and beta investments, and why do they matter?

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When you invest in a stock, ETF, or mutual fund, you do so with the expectation of certain kinds of returns and after assessing the risk involved. You may evaluate the risk-return profile of an investment based on the past performance of the security, the current market sentiment, the industry performance, or the fund manager involved. 

The most prudent aspect to focus on is the numbers that objectively reflect an investment’s performance. And Alpha and Beta, two popular ratios, can help you do so. These ratios help predict and compare an investment’s risk and returns to the overall market performance.

What is alpha?

Alpha is used to evaluate the performance of an investment, such as a stock or fund, or a portfolio by measuring the returns it has generated in comparison to a specific market index or benchmark.

Say, for instance, a fund has an alpha of 2 and the index it is compared against is the S&P 500. This would indicate that the fund has outperformed its benchmark index by 2%. However, if the alpha was -1, this would mean that the fund underperformed its benchmark index by 1%. An alpha of 0 would mean that the investment returns match the index.

Why does it matter?

Alpha is an important number to look at when it comes to active investing. Active investing is a hands-on approach where someone, typically a portfolio or fund manager, constantly tracks the performance of the market and makes strategic decisions to capitalise on price fluctuations and provide higher returns than the market average. 

Actively managed funds have a higher cost involved because there is a fund manager who uses his expertise to determine asset allocation and achieve the fund’s objectives. Hence, alpha, in addition to showing you how your investment is fairing, also tells you whether the fund manager is truly able to provide returns that are outperforming its benchmark index. 

What is beta?

Every investor knows that the markets are volatile and hence returns are not guaranteed. However, to make investment decisions that are calculated and don’t feel like a gamble, it’s important to assess the degree of volatility and risk involved. Beta is a key risk ratio that helps you do that. It helps evaluate the volatility of an investment or a portfolio in comparison to the market. 

Since the market is vast and varied, a benchmark index, usually the S&P 500, is used as a proxy measure for the overall market. The baseline number for beta is 1 and it indicates that the investment’s price fluctuations are in line with the market. A beta of more than 1 shows that the investment is more volatile than the market, while a beta of less than 1 indicates that the investment is less volatile than the market. If a stock has a beta of 1.4, that would indicate that it’s 40% more volatile than the broader market. 

Why does it matter?

Beta forms an essential component of the Capital Asset Pricing Model (CAPM). The CAPM is used to map out the systematic risk and estimated return relationship for securities such as stocks. The purpose of using this model and beta is to figure out if a particular security is valued in line with the degree of risk involved and the expected returns. 

Hence, when figuring out the asset allocation that works well for your portfolio based on your risk appetite and financial goals, beta can be a helpful ratio. Experts believe that beta is a useful measure to assess short-term risk rather than long-term risk. 

What are smart beta investments?

Smart beta investments are customised indexes or ETFs that aim to lower the beta, enhance the alpha, and improve diversification, all at a cost lower than traditional active investing. They are created using index construction strategies that are different from the traditional market capitalisation method. 

Most of the traditional indexes, including the S&P 500, primarily use market capitalisation to rank and weigh companies. They tend to disregard other factors and indicators of growth. What this means is that the companies that are larger have a higher weight in the index and hence a higher impact on the overall performance of the index. So even if the companies that are smaller have the potential for growth or if the bigger companies are overvalued or volatile, that’s not taken into consideration when allocating weights to them. There’s a sort of size bias in such indexes. 

Smart beta investing, on the other hand, doesn’t place such emphasis on market capitalisation and uses a set of other objective rules-based parameters. While screening the companies for a smart beta index, the companies are weighted on the basis of a predetermined set of factors such as volatility, value, liquidity, quality, etc. to decide which companies get the bigger share of the index. This means that when investors invest in smart beta investments, there is a higher probability of enjoying returns that outperform benchmark indexes and thereby improve the overall performance of their portfolio.  However, the jury is still out as to which smart beta investments do work as promised and which ones don’t. The weightage of parameters used to determine smart beta investments are still evolving and need to be validated by long-term market returns.

How can you add smart beta investments to your portfolio?

The best way to add smart beta investments to your portfolio is by investing in smart beta ETFs. However, smart beta ETFs are relatively new in India and are mostly based on one factor. To really benefit from the strategic customisation for risk-return profile that goes into smart beta investments, you can consider investing in U.S. smart beta ETFs. As per data by Invesco, many U.S. ETFs built using smart beta investing methodologies outperformed the S&P 500 index for five whole market cycles.
With Appreciate, you can access a wide range of smart beta stocks and ETFs in the U.S market to enjoy higher returns and build a diversified portfolio that helps you achieve your financial goals quickly and seamlessly. To learn more about adding smart beta investments to your portfolio, sign up on Appreciate.

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