Alpha and Beta: More Bang for Your Buck

Why do I need to know about Alpha and Beta?

As you build out a portfolio over many years, you will likely find your goals changing. The young, hard-charging investor will be willing to take on large risks in pursuit of large returns. The retiree will want to avoid large losses, even if it means missing out on larger gains.

It is easy to say you are willing to "take higher risk" or "want to avoid risk," but we need some way of measuring risk. That measurement is called Beta, or β if you are in a frat. Beta measures the volatility of a stock, ETF, fund, or portfolio versus the market overall. "The market" would vary by country, but in the U.S., we measure the market through the S&P 500.

Aggressive investors will want a high Beta so they can benefit from the extra volatility on large bullish moves. Conservative investors will want low Beta so they can avoid large losses when the market turns sour. We will cover this thoroughly in the next section.

In addition to Beta, we also have Alpha, or α. Alpha is a measurement of how an asset (or asset manager) performs relative to its Beta. We need to understand Beta before talking about Alpha. Let's discuss Beta first.

Beta: A measure of volatility

Beta measures how volatile something is compared to the market. In other words, if the market (S&P 500 in the U.S.) goes up by 1%, how much should we expect our asset to go up? More than 1%? Less than 1%? Or will it actually go down as the market goes up?

The default Beta is 1.00, which means whatever you are measuring moves perfectly in line with the S&P 500, like SPY itself, the ETF that tracks the S&P. A Beta of more than 1.00 indicates that the asset moves more dramatically than the market. A Beta of less than 1.0 means the asset moves less than the market. 0.00 would mean the asset has no relationship to the market at all. Fixed-income funds or certain bonds would get close to 0.00 Beta. It is also possible to have a negative Beta, which indicates the stock moves in the opposite direction of the market. Certain funds like SPXS have a negative Beta.

The 3x-leveraged NASDAQ ETF, ticker TQQQ, for example, has a Beta of 3.43. This indicates that it will move ~3.43x whatever the S&P 500 does. If SPY goes up 3%, expect TQQQ to go up over 10%. Likewise, expect it to drop over 10% if SPY tanks 3%.

It is theoretically possible for Beta to go to infinity in either direction. But only a few meme stocks land outside of -4.00 to 4.00. 

Source: Yahoo Finance

MARA is a company that mines Bitcoin and is probably riding some serious meme stock energy right now. It has a Beta of 4.32, which is extremely high. Aggressive investors would love MARA's large moves, whereas conservative investors want nothing to do with such a volatile stock.

Keep in mind that Beta tracks monthly averages, not daily. Do not anticipate linear moves perfectly in line with a stock's Beta each day.

How can I find my Beta?

That will depend on your broker. Merrill Edge offers a tool through Morning Star that calculates this for me, although I am on my work computer and cannot access it now to take a snapshot (I will do this later and update). However, every broker is different and your may not offer such a tool at all. I am confident that Robinhood does not.

If your broker does not have a portfolio analysis tool, you will need to take the individual Betas from each of your positions off of Yahoo Finance and calculate it as a proportion of your overall portfolio, then average everything together. You might be better off estimating, but as long as you are relatively close, you should have enough information to take action.

How Beta affects gains and losses:

Let's look at QQQ, my largest holding. QQQ is an ETF that tracks the NASDAQ (tech sector).

QQQ has a Beta of 1.04, so it is slightly more volatile than the S&P 500 and its ETF, SPY. With a Beta of 1.04, I should anticipate that my QQQ holding will move about 4 basis points (4%) more than SPY throughout a month. This also indicates the technology sector is about 4% more volatile than the market at large.

This 4% figure does not mean QQQ will go up 6% when SPY moves by 2%. Rather, it means QQQ will go up by 104% of SPY's 2% move. This would entail QQQ going up 2.08%. It is hardly a noticeable difference.

SMH is another holding of mine. SMH tracks the semiconductor sector (microchips etc.). It has a Beta of 1.24. This indicates that the semiconductor sector is 24% more volatile than the overall market. If SPY goes up 1%, I should expect SMH to go up by about 1.24%. If SPY goes down 10% in a bad month, SMH will drop by something more like 12.4%.

For good measure, we can look at TZA, an inverse ETF that moves 3x opposite the small cap market Russell 2000. It has a Beta of -3.15. This means that if SPY drops 2%, TZA will go up about 6.3%. If SPY goes up 4%, TZA should drop about 12.6%.

What does this mean for my risk management?

Like I stated in the opening paragraph, your needs are going to change as you get further in your investing career. You may also want to hedge against losses when you expect the market to drop in the future. You should, at the very least, generally be aware of how volatile your portfolio is at any given time.

1) Managing your volatility profile to meet your needs: Are you a conservative investor looking to pull slow, reliable gains in retirement? You will want a low-Beta portfolio in order to ensure you don't get wiped-out when the market crashes. You can afford to miss out on big years when the market goes up 20%. You are fine with returning only 10%, because after all, you are retired anyway. If you're an aggressive investor, take on a higher Beta and take advantage of high volatility in positive years. If your Beta is 1.4, then you will beat the market when stocks go up.

2) Hedging: There are two methods of using Beta to determine how to hedge.

Hedging with shares: If someone determines that they are too heavy on Beta, they may want to Beta hedge. This means taking some positions that would counter your high Beta to ensure you aren't crushed by a small market downturn. If the Beta on your portfolio overall is 1.50, this could be too high for your needs. To Beta hedge, you can just take a straight negative-beta position like SH, which has a Beta of -0.90. This will help balance the portfolio without having to sell shares and incur taxes. 

However, the above may be too aggressive, and another method of Beta hedging is to simply take on some positions with a Beta less than 1.0, but still positive. KO is a good example, with a Beta of about 0.47. KO will ride out a market decline better than the average stock, which adds resiliency to a portfolio and dulls the Beta without having to take on a bearish position.

Hedging with Options: Sometimes, you will want to hedge your portfolio against sharp losses in the short term. If someone is holding a bunch of different stocks but expects the market to drop, he may want some protection. Selling the stocks would incur taxes, and he doesn't necessarily want a large SH share position, so he may want to buy puts instead. But how many puts should he buy? He should refer to his portfolio's overall Beta. 

If he has a $400,000 portfolio, his first instinct will be to buy 10x puts on SPY at the $400 strike. Those puts will represent $400k of SPY shares, so he will be protected if the market drops, right? Not quite. If his portfolio has a Beta of 2.0, then 10x SPY puts won't cut it. He should expect that his 2.0 Beta will drop twice as much as the market, so he needs 2x the protection. He would need 20x puts for the same level of protection as 10x puts if his Beta were 1.0.

3) Determining your benchmark: If you have a portfolio invested heavily in a specific sector, it may make sense to keep the portfolio's Beta in-line with an ETF for that sector. For example, if you are a healthcare investor, ensure you are not over or under-weighing yourself by deviating too far from IYH's Beta of 0.76 since stocks in the same industry move together.

Alpha: Getting the right return for your risk

It is trendy to "outperform the market." This is a commonly-stated phrase when someone wants to boast of trading success. However, if your portfolio has a Beta of 1.75, beating the S&P 500 may not be enough to justify the risks you took on by carrying a more volatile portfolio.

Alpha is a measurement of how well a stock, portfolio, or portfolio manager performed after adjusting for Beta.

How do we measure Alpha?

Let's pretend you have that 1.75 Beta portfolio in a year in which SPY goes up 10%. If you got a 12% return that year, did you really beat the market? Eh.

You had a portfolio 75 basis points more volatile than the S&P, but you only beat it by 2% overall. You took on the additional risk of holding volatile positions all year, but did not receive a proportionate return. You should be rewarded with a 17.5% return when the market goes up 10%, but you did not.

Versus your Beta, you actually underperformed by 5.5%. This means your Alpha was -5.5% for the year. That does not mean you suck. After all, you did perform better than the S&P. However, you did not get adequately rewarded for your risk, and therefore you may need to adjust your portfolio.

On the other hand, if your portfolio has a Beta of 0.50 and you made 7% that same year, then did you underperform the market? You made 7% while the market went up 10%. In that sense, you underperformed. But you also took on less risk by holding a portfolio with 1/2 the volatility of the S&P. While that portfolio would have an expected return of 5% that year, yours got 7%. You, and your portfolio, have an Alpha of 2%.

This does not mean the second scenario is better. After all, you had a much higher gain in the first example. Alpha simply shows that you were more efficient with your risk in the second example.

How can I use Alpha when I invest?

1) Choosing a fund: Most people use Alpha to evaluate fund managers. If you are reading this, you probably do your own investing, so you are unlikely to comb through mutual fund managers to invest with. However, old-timers and probably some people you know will look at a mutual fund's past performance and stick their money in the highest earner.

It is snazzy to pick a fund whose manager can boast a 14% return when the market went up 10%. He beat the market. That is, until you look at the portfolio and see a Beta of 1.90. No shit the fund beat the S&P. It is almost 2x as volatile. To merit a 1.90 Beta, the fund should be returning about 19% when the market goes up 10%. This fund had an Alpha of -5% because it returned 14% instead of the Beta-merited 19%. On the other hand, if the same portfolio returned 22%, it would have an Alpha of 3%.

It is also important to look at longer-term historical performance instead of a single year. Kanye West conquered the market by going all in on AAPL in a year in which the stock doubled. He had Alpha that year. But does Kanye West really have Alpha? Probably not, he just got lucky with AAPL in a good year. Look at trends over several years to determine Alpha.

Investing in a portfolio with the highest Alpha is probably not the best approach either. You still need to consider your risk profile overall. However, it is definitely a factor to consider rather than going off return alone.

2) Evaluating your own performance: It is important to go through reflection. Take a look at your portfolio's overall Beta and compare it to an appropriate benchmark. Merrill Edge makes this pretty easy for me, but your broker may not have this feature, forcing you to go through it manually. 

If I compare myself to SPY, I am totally destroying the market. I am more than doubling its performance. But I have to consider my Beta before I consider this a success. If I have a high Beta, I'd better be killing SPY. If SPY has a Beta of 1.0 but my Beta is higher, plus I am more invested in tech than SPY, maybe the S&P is not a good benchmark for me. 

Since I am heavily invested in tech, QQQ is probably a better benchmark for me. I am slightly ahead of QQQ, although there have been times in which I lagged QQQ. This may make sense because I usually carry some cash and dividend stocks, and I sell covered calls that get assigned more often than I would like. To determine if outperforming QQQ by 500 basis points is good or not, I need to compare my Beta to QQQ's 1.04. 

Unfortunately, I cannot access the MorningStar add-on since my work computer is blocking it, and so I cannot find out my Beta right now. I will have to check later and update this post. I think it is likely that I have a slightly negative Alpha because I am probably more volatile than QQQ, enough so that it does not compensate for the 5.02% outperformance, especially after taxes are considered. 

What does this mean for me? It means I probably have to stop shooting myself in the foot by rolling ITM covered calls, and instead take assignment and convert the money into another play. Cash has a 0.00 Beta, but still counts as portfolio balance, so I am probably dulling my performance by holding cash and by rolling deep ITM covered calls that provide little return but tie-up large amounts of buying power.

If I never reflected on my Alpha, I might have never really considered this. But now that I look at my Alpha instead of just straight performance against the market, I see that I can do even better.