Learning the ABCs of alpha and beta stock performances

Most investors hope to earn better-than-average returns.

According to Bill Montague, Consulting Group senior financial writer, this is particularly true of those who use professional asset managers. One of the main arguments - although hardly the only one -for active management is that it allows individual investors to benefit from the skill of experienced experts, improving performance in the long run.

In Wall Street jargon, this quest for above-average performance is often referred to as the search for "alpha." Managers who outperform an appropriate market benchmark, such as the S&P Index for large capitalization equity portfolios, are praised for showing "positive alpha." Those who fail to match the market's performance are chastised for producing "negative alpha."

But many investors fundamentally misunderstand what these terms mean. They equate manager performance with raw returns, usually measured over a short-term period such as a quarter or a year and ignore the other factors (such as risk) that determine whether a manager's decisions have generated positive or negative alpha.

As a result, investors may end up selecting managers that are inappropriate for their own needs. They may also be disappointed to find that what appeared to be a clear track record of past performance is followed by an extended period of underperformance, either relative to the market or to their own expectations.

To understand alpha, it helps to know a little bit about the financial framework that underpins the investment analysis process. This framework, known as "modern portfolio theory," holds that there is a relatively predictable relationship between risk and return, both for individual securities and for diversified portfolios.

In general, the greater the risks, as measured by the volatility of returns over time, the greater the return that investors should expect to earn for taking those risks.

Not all risks are equal, however. Some of the volatility of a particular stock or equity portfolio is caused by its sensitivity to price movements in the broader market. This is called market risk.

Other sources of volatility stem from specific factors related to each stock in the portfolio, such as a company whose earnings come in higher or lower than expected. This is called stock-specific or company risk.

Market risk is expressed by a statistic called "beta," which measures the degree to which returns on a stock or a portfolio are sensitive to changes in the returns of the broad market. In most measurement systems, the S&P 500 Index is used as a market proxy, giving it a beta of one.

In theory, the higher the beta, the higher the long-run expected return on a stock or a portfolio. But that still leaves company risk and the portfolio fluctuations it can cause. In theory, such volatility can be reduced through diversification. Adding stocks to a portfolio increases the odds that individual price movements will cancel each other out, leaving only the volatility caused by broad market movements, by beta.

In theory, an investor could eliminate company risk entirely by buying every stock in the S&P 500 Index, an investment strategy known as indexing. His or her returns would never be lower than the market although they would also never be higher.

Alternatively, investors could choose to add higher beta stocks to their portfolios, in hopes of earning a higher return. Or, they could replace high beta stocks with low beta stocks, in an effort to reduce risk. Either way, it wouldn't reflect any particular skill at picking stocks or timing buy and sell decisions, just a willingness to accept more or less risk.

If, however, an investor or a portfolio manager can select stocks that consistently post returns higher than the market average due to specific company factors such as better-than-expected earnings or a growing perception that the stock is undervalued, those gains would constitute positive alpha.

In other words, portfolio returns would be higher than what you would expect given the amount of market risk accepted.

Every investor wants his or her portfolio manager to be above average, usually defined as beating the return on some widely known benchmark, such as the S&P 500 Index. But that standard provides only the roughest of rough guides to manager performance.

Alpha does a much better job of distinguishing manager skill from blind luck or the unearned benefits of market cycles. But here, too, investors can be misled by recent past performance or by factors not adequately captured by standard statistical tools.

For a copy of Consulting Group's full report or more information on alpha, e-mail william.a.creekbaum@smithbarney.com or call 689-8700.

Smith Barney does not provide tax and/or legal advice. Please consult your tax and/or legal advisers for such advice.

• William Creekbaum, MBA, CFP, a Washoe Valley resident, is senior investment management consultant of SmithBarney, a financial services firm serving Northern Nevada at 6005 Plumas St., Ste. 200, Reno.