Alpha and beta: What are you paying for?
25 January 2018 | Portfolio construction
Leo Schulz: Alpha and beta, what are you paying for? Investors are always being offered all sorts of investment strategies. Is it clear that they understand the sources of investment return, and does it matter?
My name is Leo Schulz. I have with me Neil Cowell, Head of UK Intermediary Distribution at Vanguard Europe. Neil, why is it important for investors to understand the sources of their return?
Neil Cowell: We think it's very clear that investors should understand the different sources of return and understand, therefore, what they are paying for; the difference between the beta and the alpha. Beta is, of course, the market return and the return that could be expected from a given market, for example, FTSE 100. Whereas the alpha is a fund manager's attempt to add value by providing a return greater than that market.
Leo Schulz: Neil, this chart here – this represents the return of six multi-asset funds currently available in the UK, in relation or relative to Vanguard LifeStrategy 60% Equity Fund, which we're using as a proxy for global markets. What do you want us to see in this chart?
Neil Cowell: Well, this is the alpha; this is the fund manager's attempt to add value by achieving a return greater than that market. And you can see from this chart that there is quite a variety of returns, and that for better or for worse, investors here are getting a return different to the marketplace.
Leo Schulz: So if we look then at the second chart, Neil, we have got the same six funds and we have added LifeStrategy 60% Equity Fund back in, what's the message that we're looking for in this chart, Neil?
Neil Cowell: Well, as you have said here, we have taken that alpha that we have previously looked at and now overlaid it with the market return, the beta, and when you do this, you can see just how much that beta overwhelms the alpha and the returns follow a very similar pattern.
Leo Schulz: Where it's just the alpha we see a difference in returns, quite a striking difference in returns, but when we have the beta and the alpha together, which would be the total return, we see that the pattern of returns is really quite similar. Does that sum up what you're saying?
Neil Cowell: That is exactly right, and of course the message there is that the power of the beta is very strong. The majority of those returns are coming from the market.
Leo Schulz: Neil, here we are looking at a few funds, very popular funds as they are over a five-year period, but what is the evidence that this is a factor in returns, more broadly and over longer periods?
Neil Cowell: Leo, there have been many studies on this very theme since the '60s, actually, and time and time again the evidence points to the same thing, which is that 80% of the variance in returns that an investor receives is due to the market or to the beta. It's only around 20% that is attributable to a fund manager's skill, and it's very important to understand that that 20% might not necessarily be a positive contribution.
Leo Schulz: So while both the beta and the alpha can add value to an investment, it's important to understand which of them you're getting and how much you are paying for each.
Neil Cowell: That's exactly the message, Leo.
Leo Schulz: Understanding the sources of investment return gives investors the ability to know what they are getting for their fees. If you are paying for alpha, that is what you should receive, bearing in mind it can be both positive and negative.
Neil Cowell, thank you very much.
Neil Cowell: Leo, thank you.
This video is directed at professionnal investors and should not be distributed to, or relied upon by retail investors.
This video is designed only for use by, and is directed only at persons resident in, the UK. It is for educational purposes only.
The value of investments, and the income from them, may fall or rise and investors may get back less than they invested. Past performance is not a reliable indicator of future results.
The material contained in this video is not to be regarded as an offer to buy or sell or the solicitation of any offer to buy or sell securities in any jurisdiction where such an offer or solicitation is against the law, or to anyone to whom it is unlawful to make such an offer or solicitation, or if the person making the offer or solicitation is not qualified to do so.
The information on this video does not constitute legal, tax, or investment advice. You must not, therefore, rely on the content of this presentation when making any investment decisions.
The opinions expressed in this video are those of individual speakers and may not be representative of Vanguard Asset Management, Limited
Issued by Vanguard Asset Management, Limited which is authorised and regulated in the UK by the Financial Conduct Authority.