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  • DualBeta: A New Perspective On Alpha And Beta 0 comments
    Feb 27, 2012 11:56 AM

    Everyone wants to be smarter than the market. Isn't that why we (or maybe just I) read articles on this forum all the time? Everyone wants to find the best-in-breed stocks before everyone else, and especially Wall Street analysts, knows about them.

    Well, I'm not promising you a crystal ball that does this for you, but I have used a site as part of my recent analysis which offers free and subscription-based services to help in stock analysis. Your first thought is probably, this guy works for the site he is telling us about. You would be wrong. I found this site basically randomly roughly a year ago.

    The site's name is www.DualBeta.com, and what the site offers which I find most useful is up-market and down-market betas and alphas. Essentially, the authors of this site have done research suggesting that companies perform systematically differently when the market is up versus when the market is down.

    For those of you who have not been exposed to Beta and alpha, I will attempt a brief introduction. It is based on a theory called the Capital Asset Pricing Model(CAPM). If you have, skip the next few sections. The formula is below:

    Asset's Expected Return = Risk-free rate + Beta(Market Return-Risk-free rate)

    By convention, the risk-free rate is often one of the Treasury Bill interest rates, although many might argue T-Bills are no longer risk-free. We'll use an interest rate of 3% which is roughly the 10-year T-Bill rate. Anyways, the market return is often taken as the historical market return, which since the Great Depression, has averaged 7%. You can make arguments for other numbers, but we'll use 7%.

    I like using mathematical examples to solidify the concepts. So, with a Beta of 1, The expected return is thus 7%(identical to market return because the beta of the market is assumed to be 1). However, if we add leverage and get a 1.5 beta, expected return becomes 9%. Now, under this scenario, the investor who holds the 1.5 beta asset outperformed the market by 2%, but invested in a riskier asset to do so. More risk=more expected return is the core theme of CAPM.

    Now, alpha is just one step in addition to calculating beta. Alpha measures the return of an asset above and beyond its expected return. So, using our example above, the expected return on a 1.5 beta asset is 9%. A return of 10% would have a 1 alpha, denoting the investor achieved a 1% return above what the market expected. Similarly, a return of 9% on the 1.5 beta asset would correlate to a 0 alpha, since the investor earned exactly the return the market predicted.

    This concludes my lesson on CAPM. I hope this part was useful for those unacquainted with it.

    Back to Dual Beta. So, this site offers for free, the alphas and betas of companies over 1-11 year time periods, along with a host of other metrics, such as the Sharpe and Treynor ratios. Again, the site displays the standard alpha and beta, as is often reported, but also displays the up-market and down-market betas and alphas.

    In theory, one could determine whether their asset outperformed the market in both good and bad times, or just in good times but not bad times.

    I would argue that a stock that shows up with negative alpha in a down-market could still be a great company to own as long the up-market alpha compensates for the underperformance during down markets, i.e the up-market alpha is higher than the down-market alpha.

    I've added a screenshot so you get a feel for the layout of the site.

    I want to reiterate that in no way am I compensated by the creators of DualBeta.com for writing this or any other articles. I think this information could be useful to some of you. You can learn more about the creators of DualBeta.com at www.c4cast.com

    Good luck investing!

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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