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Summary

  • In every asset class, there are market environments where either the beta approach works best or the alpha approach, but rarely both.
  • In a beta-dominant market, e.g. 2009-2010, 2012-2013 for the S&P 500, a buy and hold, high-beta portfolio would have outperformed an alpha-oriented portfolio.
  • In an alpha-dominant market, e.g. 2008, 2011 an alpha-oriented portfolio with short holding periods and active trading would have outperformed a high-beta portfolio.

Market Environments

Every asset class goes through market environments which can be categorized under the following 3 types:

1. Trending Market

This market is defined as one that is made up of a series of smaller periods with a relatively constant rate of return, such that the instantaneous volatility of returns as measured per smaller time slice is close to zero.

2. Shock Market

This market is one that is made up of a series of smaller periods with high volatility and low volatility.

3. Noise Market

This market is one that is made up of a series of smaller periods with a relatively constant volatility. A noise market bears no trend.

Please see the complete paper for more information on the volatility periods.

Alpha vs. Beta Investing

Beta is simply a measure of how correlated an asset is to its underlying market. A beta of 1 means that the asset will rise and fall in unison with the market. A beta of higher than 1 means that the rise and fall will be larger, and for an asset of beta less than 1, the rise and fall will be smaller than the market.

Alpha is a measure of the outperformance of an investment versus its market benchmark after taking beta into account.

An investor can take two very distinct approaches to investing, depending on the market environment. Here are some of the main differences between the 2 styles of investing.

Characteristics

Alpha Investing

Beta Investing

Best Market

Noise or Shock market, as defined earlier.

Trending market, as defined earlier.

Worst Market

Trending Market

Noise or Shock market

Holding Period of Positions

Short Term

Long Term

How do you make money?

Active trading to take advantage of up and down market swings

Buy and hold and let the trending market do the job for you

Risk Management

Active and frequent to protect profits and cut losses at the expense of giving up some upside

Infrequent, as the cost of protecting profits is too high when compared to the expense of giving up upside

Portfolio Construction

Several assets that are uncorrelated to each other

Several high beta assets that will rise and fall more than the market

Why do Alpha and Beta investing rarely work at the same time?

The best way to understand this by looking at the following chart, which shows the returns of beta investors in the S&P 500 from 2007-2013 versus the returns of an average alpha investor over the same period.

1 Beta, 2 Beta, 3 Beta show the returns of investors invested in stocks that trade at a beta of 1, 2 and 3 respectively to the S&P 500.

The Average Alpha Investor shows the average returns of an alpha investor with a strategy using different model accuracy rates and risk management limits.

(click to enlarge)

Source: MA Capital Management, Yahoo Finance

The above chart shows that the beta investors performed very well both on an absolute level, as well as compared to the alpha investor in 2009-2010, as well as 2012-2013.

But the alpha investor did very well in 2008 and better than the beta investor in 2010.

The chart clearly shows that alpha and beta investing rarely go hand in hand. Certain markets are better for beta investing, while other markets are better for alpha investing.

It is quite easy to calculate the returns of a beta investor, as it is just the sum of the daily returns, assuming a buy and hold strategy. But it gets a little tricky to calculate how a typical alpha investor would perform.

An alpha investor's returns depend on 3 main things:

1. The accuracy of his calls. The trading calls can be driven by fundamental, technical or complex systematic models.

2. A risk management system to reduce the losses on incorrect calls.

3. Volatility of the market's daily moves.

The chart above shows various scenarios of trading model accuracy as well as the daily risk management limits. Additionally, volatility in both directions is essential for alpha investing. Larger the daily moves in the market, more profits the alpha investor can generate from his strategy.

Further discussion on this can be found in the full paper.

Disclaimer: Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. No advice may be rendered by MA Capital Management, LLC unless a client service agreement is in place. Nothing in this presentation should be construed as a solicitation or offer, or recommendation, to buy or sell any security, or as an offer by MA Capital Management, LLC to provide advisory services. Investment management services are offered only pursuant to a written Customer Agreement, which investors are urged to read and carefully consider in determining whether such agreement is suitable for their individual facts and circumstances.

Source: Investing In Beta Versus Alpha Dominant Markets