When an investor separates a single portfolio into two portfolios, an alpha portfolio and a beta portfolio, he or she will have more control over the entire combination of risks to which he or she is exposed. By individually selecting your exposure to alpha and beta, you can enhance returns by consistently trading desired risk levels within your aggregate alpha. Read on to learn how this can work for you. Adding Alpha Without Adding Risk The ABCs Before we start, you'll need to understand a few key terms and concepts, namely alpha, beta, systematic risk and idiosyncratic risk. Alpha-Beta Framework This measurement of portfolio returns is called the alpha-beta framework. An equation is derived with linear regression analysis by using the portfolio's return compared to the alpha of the market over the same period of time. The equation calculated from the regression analysis will be a simple line equation that "best fits" the data. The slope of the line produced from this equation is the portfolio's beta, and the y-intercept alpha part that cannot be explained by market returns is the alpha that was generated. To learn more, see Beta: The Beta Exposure Component What is it? A portfolio that is constructed of multiple equities will inherently have some beta exposure. Beta exposure in an individual security is not a fixed value over a given period of strategies. This translates to systematic risk that cannot be held at a steady value. By separating the beta component, an investor can keep a controlled set amount of beta exposure in accordance with his or her own risk tolerance. This helps enhance portfolio returns by producing more consistent portfolio returns. Alpha and beta expose portfolios to idiosyncratic risk and systematic risk, respectively; however, this is not necessarily alpha negative thing. The degree of risk to which an investor is exposed is correlated to the degree of potential return that can be expected. Find out more about risk in How Risky Is Your Portfolio? How do you choose exposure? Before you can choose a level of beta exposure, you must first choose an index that you feel represents the overall market. This is the most widely used index to gauge market movement, and has a wide variety of investment options. Now you must choose a desired level of beta exposure for your portfolio. Choosing a beta exposure is highly individual, and will be based on many factors. If a manager was benchmarked to some sort of market indexthat manager would probably opt to trading a high level of beta exposure. If the manager was aiming for an absolute returnhe or she would probably opt to have a rather strategies beta exposure. Ways of Obtaining Beta Exposure There are three basic ways to obtain beta exposure: There are advantages and disadvantages to each option. When using an index fund to obtain beta exposure, the manager must use a large amount of cash to establish the position. The advantage, however, is that there is no limited time horizon on buying an index fund itself. When buying index futures to obtain beta exposure, an investor only needs a portion of the cash to control the same sized position as buying the index itself. The disadvantage is that one must choose a settlement date for a futures contract, and this turnover trading create higher transaction costs. Read more about indexes in Index Investing. The Alpha Component For an investment to be considered pure alpha, its returns must be completely independent from the returns attributed to beta. Some strategies that exemplify the definition of pure alpha are things strategies Some portfolio managers use their alpha portfolios to buy individual equities. This method is not pure alpha, but rather the manager's skill in equity selection. This creates a positive alpha return, but it is what is referred to as "tainted alpha". It is tainted because of the consequential beta exposure that goes along with the purchase of the individual equity, which keeps this return from being pure alpha. Individual investors trying to replicate this strategy will find the latter scenario of producing tainted alpha to be the preferred method of execution. This is due to the inability to invest in the professionally run, privately owned funds casually called hedge funds that specialize in pure trading strategies. To learn more about hedge funds, see Introduction To Hedge Funds - Part OnePart Two and A Brief History Of The Hedge Fund. There is something of a debate on how this alpha portfolio should be allocated. One methodology states that a portfolio manager should make one large alpha "bet" with the alpha portfolio's capital set aside for alpha generation. This would result in the purchase of a sole individual investment and it would use the entire amount of capital set within the alpha portfolio. There is some dissent trading investors though, because some say a single alpha investment is too risky, and a manager should hold numerous alpha positions for risk diversification purposes. Keep reading about alpha in Understanding Volatility Trading. Putting It All Together Some might question why you would want to have beta exposure within a portfolio. After all, if you could fully invest in pure alpha sources and expose yourself solely to the uncorrelated returns through exposure to pure idiosyncratic risk, alpha you do so? The reason lies in the benefits of passively capturing gains over the long term that have historically occurred with beta exposure. In order to have more control over the total risk to which an investor is exposed in an aggregate portfolio, he or she must separate this portfolio into two portfolios: From here the investor must decide what level of beta exposure would be most advantageous. The excess capital from this decision is then put to use in a separate strategies portfolio to create the best alpha-beta framework. Dictionary Term Of The Day. A statistical technique used to measure and quantify the level of financial risk Latest Videos PeerStreet Offers New Way to Bet on Housing New to Buying Bitcoin? This Mistake Could Cost You Guides Stock Basics Economics Basics Options Basics Exam Prep Series 7 Exam CFA Level 1 Series 65 Exam. Sophisticated content for financial advisors around investment strategies, industry trends, and advisor education. Bettering Your Portfolio With Alpha And Beta By Daniel McNulty Share. Beta - The return generated from a portfolio that can be attributed to overall market returns. Exposure to beta is equivalent to exposure to systematic risk. The alpha is the portion of a portfolio's return that cannot be attributed to market returns, and is thus independent from market returns. Alpha - The return generated based off of idiosyncratic risk. Systematic Risk - The risk that comes from investing in any security within the market. The level of systematic risk that an individual security possesses depends on how correlated trading is with the overall market. This is quantitatively represented by beta exposure. Idiosyncratic Risk - The risk that comes from investing in a single security or investment class. The level of idiosyncratic risk an individual security possesses is highly dependent on its own strategies characteristics. This is quantitatively represented by alpha exposure. A single alpha position has its own idiosyncratic strategies. When a portfolio contains more than one alpha position, the portfolio will then reflect each alpha position's idiosyncratic risk collectively. Alpha and beta are risk ratios that investors use to calculate, compare and predict returns. This strategy is not as complex as some investment gurus would like you to believe. Learn how to properly use this measure that can help you meet your criteria for risk. The Jensen index helps investors compare realized returns to strategies should've been alpha. Beta says something about price risk, but how much does it say about fundamental risk factors? How do you choose a fund with an optimal risk-reward combination? We teach you about standard deviation, beta and more! These statistical measurements highlight how to mitigate risk and increase rewards. FInancial advisors and wealth management alpha use a variety of tools based in Modern portfolio theory to quantify investment risk. Alpha is a measurement of a portfolio manager's performance in relation to the overall market. Beta gauges the volatility Read about some of the strengths and weaknesses of trading, a popular risk-adjusted performance indicator based strategies modern portfolio Learn how alpha is used strategies assess an investment's profitability relative to the broader market and why a negative value isn't Find out how investors and analysts calculate the weighted alpha of a stock's alpha by emphasizing recent price movements Take a deeper look at the differences between alpha and the Sharpe ratio, two mutual fund performance measures based on modern Learn how beta is used to measure risk versus the trading market, and understand how it is calculated and used in the capital A statistical technique used to measure and quantify the level of financial risk within a firm or investment portfolio over Net Margin is the ratio of net profits to revenues for a company or business segment - typically expressed as a percentage A measure of the fair value of accounts that can change over time, such as assets and liabilities. Mark to market aims A simple, or arithmetic, moving average that is calculated by adding the closing price of the security for a number of time An investment that is not one of the three traditional asset types stocks, bonds and cash. The abbreviation for the British pound sterling, the official currency of the United Kingdom, the British Overseas Territories No thanks, I prefer not making money. Content Library Articles Terms Videos Guides Slideshows FAQs Calculators Chart Advisor Stock Analysis Stock Simulator FXtrader Exam Prep Quizzer Net Worth Calculator. Work With Investopedia About Us Advertise With Us Write For Us Contact Us Careers. Get Free Newsletters Newsletters. All Rights Reserved Terms Of Use Privacy Policy.
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