It is difficult to discuss alpha and beta without touching on Modern Portfolio Theory. The concept was developed in the 1950s and backed by the belief that it is possible to construct an “efficient frontier” for investing that would offer the maximum possible expected return for a given level of risk. A portfolio encompassing products that exhibit the characteristics of alpha and beta risk measures is needed.
Viewed from the outside, professional investment management sometimes looks like a space reserved for the best and brightest, and one that is cluttered with financial jargon, keeping the layman out.
Put simply, beta refers to the return on an investment attributable to the broader market – usually the S&P 500 – while alpha measures the return above the broader market or risk free rate. Both beta and alpha are measures of investment risk. Being correlated to the market, beta can be viewed as a measure of systematic risk while alpha captures the risk unique to a portfolio.
Over the past several years, high beta investments have performed well as the S&P 500 returned over 64% from 2010 through 2013. How do you gain exposure? The simplest way to gain beta is to buy the S&P 500 index. Directly tracking the benchmark index, this investment would carry a beta of 1.0. However, it would also be capital intensive as the S&P 500 is currently trading at around $1,800. A cheaper way of gaining beta exposure is to invest in S&P 500 futures. As with most things in life, however, there is no free lunch and the leverage available through futures carries heightened risk and transaction costs (because of the fact that the futures contracts expire every three months and must be rolled forward). Carefully planned and managed, pursuing a futures strategy can make good sense.
If the first few weeks of 2014 are anything to go by, a high beta portfolio may not continue to provide the same type of returns as it has been since 2010. Where to look next for profitable investment opportunities? Enter alpha, the uncorrelated return. As the theory goes, an alpha investment targets absolute returns and can profit regardless of the performance of the S&P 500. Alpha strategies include alternatives such as hedge funds and managed futures, which have the ability to generate solid returns in flat or down markets.
One way to generate alpha is to employ a pairs trading strategy. Essentially this strategy involves getting long one futures contract or equity while simultaneously shorting another futures or equity within the same sector.
This strategy tests the skill of the trader as both futures contracts or equities selected, being highly correlated most likely will rise or fall together with the broader market but one will rise more or fell less.
One of the first steps in pursuing this type of strategy is to identify a market sector that you understand and then pick an individual commodity or equity that you think will outperform or underperform that particular sector. For instance, if you felt WTI crude oil futures were undervalued compared to Brent crude oil, you would go long WTI and short Brent. If, over the course of the next year, WTI increases in value more than Brent or falls in value less than Brent you make money.
Energy markets are a good example of this because there are numerous factors, many of which are unknown or unknowable, affecting the energy sector, but if you can identify a mispricing in correlated markets you don’t have to worry if the sector rises or falls.