The biggest rort of all
Market performance and outperformance can come from many sources, but the main thing to watch for is that you’re not paying high ‘alpha’ fees simply to achieve market ‘beta’ returns.
As a beginner investor there are a myriad of asset classes you can invest in and it must be a bit confusing knowing where to start. So let me give you an idiot’s guide to rating investments from ‘alpha’ to ‘beta’. Stick with me.
Alpha is an expression from the funds management world used to describe the ‘excess return’ of an investment relative to a benchmark. In the industry it is used as an expression to denote how much value someone is adding to your investment returns above the average. If funds management was a gladiatorial sport the fans would be chanting “Alpha, Alpha, Alpha, Alpha!”.
Beta on the other hand represents how an investment performs relative to the market. All you need to know here is that a beta of 1 means an investment will move with the market and a low beta investment is something that moves less than the market. A beta of minus one, just to make it clear, is an investment that moves in exactly the opposite direction of the market and a beta of 2 is an investment that moves twice as much as the market when the market moves in a particular direction.
I like to think that alpha means ‘Action’ and beta is ‘Boring’.
With that little definition in mind let’s now look at the most common investments and rate them from high alpha, a lot of action, to low beta, no brain required. The first couple might surprise you but they should be on your list:
Building a business – This is a very high alpha investment, high activity, high risk but it is where all really wealthy people made their money, in business.
Your career – This is also massive alpha. Getting up, going to work, coming home for half your life. It is also, rather amazingly for a high alpha investment, about the lowest risk investment you can make. In terms of risk and reward, investing in yourself is one of the best investments in the whole world.
Then we come to traditional investments that are high alpha. These include:
Direct investment in equities and property – I have put these on a par because if you manage your own property investment or equity investment they are both hard work for similar returns. Both are very involved and both require a skill set. Both are high alpha, high activity with significant risk. They only suit you if you can service the need for action, not pretend to. This also makes the point that when weighing up which asset class is the best the answer is the one you will enjoy the most, know the most about, are more suited to managing, because both are very different activities meaning it is not really which asset class is the best, its which asset class you want to expend your alpha on.
Then comes a big drop in alpha to the first of the higher beta investments. These include managed funds and listed investment companies. It also includes the large super and industry balanced funds. These are investments that are marketed as if the managers are ‘adding alpha’ but really, the majority of them are benchmarked to an index and the moment you benchmark a professional, even if they consider themselves an ‘alpha adding’ fund manager, they unavoidably start to ‘hug the benchmark’ trying to emulate the benchmark which makes it a lot harder for them to beat it. Their investments will also become diversified across a lot of individual investments and because of that diversification these funds will never set your hair on fire despite the marketing and despite the fees. Some funds like smaller companies funds, sector funds and special situations funds may be more volatile and appear alpha orientated but even they have their benchmarks and their alpha compared to those benchmarks is more of a beta in the end even if it is more exciting.
Beta investments are things like index funds and passively managed exchange traded funds. Investments that do what they say they’ll do on the box, mechanically match an index, a market, a sector. They can be volatile, as volatile as the market they represent, but no-one is working them, they just represent an average, nothing else. And low fees.
Finally there are lower beta investments. These are investments that offer no value above the expected return. They are predictable, low risk and don’t require you to sweat them to get a return. They can’t be pushed. They include everything that offers no growth including hybrids, cash, term deposits and money under the mattress. I know a lot of people become highly concerned about the returns on these investments, but really, the main point is that you are taking very little if any risk and you are parking your money out of harm’s way instead of driving your money. The returns used to be enough to live on but they’re not anymore, pushing low risk investors into more risky investments.
The most common mistakes on this rating system are taking on a high alpha role yourself but not giving it the attention it requires and the second is the biggest rort in the investment industry, paying an alpha style fee when it’s obvious from the structure you’re only ever going to get a beta style return.
About the author
Marcus Padley is a stockbroker and founder of the Marcus Today share market newsletter. He has been advising institutional clients and a private client base for over 32 years. This article is for general education purposes only and does not address the personal circumstances of any individual.
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