Is your alpha beta than mine?
29 June 2017 | Topical insights
Commentary by Neil Cowell, head of UK retail sales, Vanguard Europe.
When an active fund manager shows you his or her performance, they are likely to emphasise the alpha, the return that they offer above and beyond the market.
This makes sense. It's the alpha – that extra return – that justifies the active manager's higher fees.
Figure 1 shows the alpha returns of six of the United Kingdom's most popular multi-asset funds1. They all have an alpha component, whether through tactical asset allocation or active stock selection, or both.
The alpha has been measured as the difference between each fund's specific return and the return of Vanguard LifeStrategy® 60% Equity Fund. (We used the LifeStrategy 60% Equity Fund because there is no widely accepted benchmark for a global multi-asset fund and LifeStrategy is Vanguard's best endeavour at capturing pure beta, the market return, in a multi-asset portfolio.)
Figure 1: Alpha for six of the most popular1 UK multi-asset funds
Source: FactSet; cumulative return in sterling, net of fees, five years to 31 March 2017 relative to Vanguard LifeStrategy 60% Equity Fund.
As we look at Figure 1 we can see that alpha returns vary greatly. They may be positive. They may be negative. But they are different. When an active fund manager pitches his or her fund, it is this difference that they emphasise.
But now look what happens when we flow the beta back into the returns, in Figure 2. It shows total return net of fees – that is, both alpha and beta. The difference between the two charts is immediately obvious, even startling.
Instead of showing wide variation, returns now move in line. Some funds do better than others but they all move in a tight formation, much like the RAF Red Arrows. The pattern of returns over time, the extent to which the lines go up and down in unison, is very nearly identical.
Figure 2: Alpha + beta for seven of the most popular1 UK multi-asset funds
Source: FactSet; cumulative return in sterling, net of fees, five years to 31 March 2017 (includes Vanguard LifeStrategy 60% Equity Fund).
The reason for this is well understood. It's because beta determines the lion's share of a portfolio's variation of returns. This has been proven in multiple academic studies conducted on a great variety of funds and fund types, in the UK and the United States and in other markets.
In the UK the mid-to-long-term influence of beta on the returns of a multi-asset portfolio is typically around 80%. In other markets, including the US, it's 90% or higher. The remaining 10%–20% of returns is due to tactical asset allocation, style biases (such as growth or value) and stock selection.
We have only run the numbers over five years as many of the more popular UK multi-asset funds do not have a significantly longer history. But if we were to run the returns over a longer period, we would suggest that the lines would close in even more. The reason being, as the studies indicate, beta is overwhelming and its effects become steadier with time.
But there is another important point that the charts illustrate. When we talk about 80% of the variance of returns being the market, or beta, and 20% the fund manager, or alpha, we tend to think that the 20% is additional positive return.
But of course it isn't. In practice, as the charts show and as the academic studies confirm, most of what active managers do is actually negative. Taking the six funds, only one has been consistently above the market over the past five years.
At Vanguard, we're impartial when it comes to the choice between active and passive investing. Where we are passionately committed is in offering investors value for money. If you are paying for alpha, that is what you should receive, bearing in mind that it can be both positive and negative.
All too often, investors pay for alpha and receive beta.
1 The funds selected are multi-asset funds commonly available to UK investors. The selection process started with a quantitative survey of funds which had significant assets under management and/or significant net client cash flows. This short-list was then reduced through a qualitative analysis to determine those funds that are available to UK investors. A third screening determined the share class most likely to be used by financial advisers.
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