It is all Greek to me
I am going to start this time with an apology. I usually try to keep these articles un-technical and as free of jargon as possible. Not this time, since jargon will play a large part in getting to the point. We are going to keep tripping over Alpha and Beta, two important terms in financial mathematics. We will also do some math, figuratively.
A key term in finance is Beta.
You can think of beta as simply an observation of how similar an investment moved with a change in the market. Some examples. If the market goes up 1% and your investment goes up 1.2% or 1.2X the market change, you have a beta of 1.2. Or, if every time the market goes up or down, your investment goes up and down in exactly the same way, you have a beta of 1. Alpha is the term used to describe the result obtained above the observed beta. If you hold investments with a beta of 1 and the market is up 10% and you earn 11%, you just earned an alpha of 1%. If you held investments with a beta of 1.1 and earned 11% on the same market gain, you earned only beta. In simplistic terms, Alpha is best thought of as the part of the return that is not beta. Somewhere, sometime, I read alpha is “I’m a genius” returns, and beta is “everyone gets paid” returns.
Having become disappointed with managers that are trying to deliver alpha, be a genius and yet have not beat the market, investors are more and more turning their attention to beta. After all, your managers suggested that you evaluate their results based on a comparison to a benchmark or index over a given time segment. This is simply the evaluation of the manager’s beta over the same time segment. It has been observed by many that their manager lags the benchmark or index frequently (on average an 85% lag), meaning that their investments returned less than the market, or less than a beta of 1. They have managed negative alpha. So, why not just capture the beta and invest in the market itself? Thus the rise of index investing to capture beta and get paid like everyone.
Here is where it gets dicey. You did poorly seeking alpha and now you might not want beta, at this time anyways and probably not this beta. Remember, beta is simply what the market itself returns. Beta is usually calculated using the daily, weekly or monthly returns against the market. Chasing beta is certainly a sure way to capture market equal returns on a day to day basis.
Almost two years ago I got a new truck. Of course, a big deal was made about how good the gas mileage was in these new vehicles. They even come with a range of graphics on the dash to demonstrate how well you are doing with your gas mileage. I watched carefully for a few months. The usage in the city on a minute by minute basis took the whole scale top to bottom. Bad to great with a release of the gas. In fact, I found I get the best mileage when braking lightly after going fast. Still eating up those kilometers, without using gas. Just haven’t figured how to get to clients by braking only. The daily average was all over the place as well. Having gained much insight about braking etc., I thought I should think longer term. I have not reset the calculator in over a year and a half.
After a few months, the average started to stabilize. It would rarely change at all day to day, unless I was all highway (or all idling with no kilometers but using gas). Now, I cannot get the average to budge (and it’s not pretty, apparently I drive too fast on the highway). No matter how or where I drive tomorrow, my truck is going to report that I am on average. Minute to minute and day to day the readings are still all over the map, but my long term gas usage is unchanging. This is a real world example of a long term trend with mountains of data. The trend is established and unwavering AND it tells us nothing about the current or short term use and vice versa.
The stock market index is a reading like the daily usage on my vehicle, up and down, up and down. How much gas I used today. Beta is the up and down on a daily, weekly or monthly basis. Is that really what you want? The long term trend, your average return, like the average amount of gas I have used in the last eighteen months, is not reported each day yet it is likely why you are in the market in the first place. You want to have a chance at earning a return similar to the long term average of the markets. Not the eighteen month average like in my truck but the 50 or 70 or 100 year average return. That was the chart your advisor showed you. It demonstrated the trend.
Exchange traded funds are the hottest way to capture beta today. The broad market index ETFs available track the markets quite closely, minus the fees. Buy today and going forward you will get what the market gets, minus the fees. Well, markets go up and markets go down. Chasing beta is certainly a sure way to get the market return, but if the market goes down, you go with it. What is forgotten is that we do not want tomorrow’s result or the next day’s result. We want to achieve the long term average return provided by the market. We want to have the trend. We want to know and be sure that over the long term we will have the same gas mileage that we have always had.
Now for the math. Sorry. You are going to do it, not me. First, for the last month I have been on vacation, driving nothing but highway miles (slowly, seeing the sights, so fabulous mileage). Am I above trend or below? Should you buy ETFs now or let me do some city driving for a while when I get back to the office? Has the stock market just out performed or underperformed? Where is it relative to the trend? If you buy above the trend line, you can never obtain the long term market average, ever. If you buy below the trend line, you may obtain more than the long term market average. Index investing is not stock investing. No alpha or genius results possible. If above trend, the math has you at a disadvantage immediately.
The last decade was disappointing for many seeking alpha from a manager. Make sure the next decade is not disappointing seeking just beta from ETFs. Our clients have been seeking the trend using ETFs and index funds for over 10 years. Shouldn’t you?
Value For Money Investing means we wish to allocate and use our hard-earned resources in order to improve investment outcomes in a continuous and sustainable way at a fair and equitable price. In other words, achieve good investment returns AND receive fair value for the services provided. Costs do matter!