Alpha and beta are two key investment concepts. So, which is which - and what do they mean for investors?

The return from your managed fund is more complicated than it looks. Investment theorists break it into two parts: Alpha and Beta.

The Beta return is the return you get from the market, often represented by an index such as the S&P/ASX 300 Accumulation Index in Australia or the Dow Jones Industrial Average in the US. The Alpha return is the additional return – the above market return an investment manager captures for you.

More than the market

The point is that while much of your return may be generated by how the overall market is performing, Alpha is generated by the manager’s skills. To take one example: the BT Australian Share Fund generated an annual average return of 10.55% over the five years to August 2009. The underlying market (in this case, the S&P/ASX 300 Accumulation Index) averaged an annual return of 9.4%. So the manager’s skill made you some extra money.[1] It’s the difference between these two kinds of return that has led to one of the great investment debates, the battle between supporters of active and passive investment.

Passive investors, such as those who favour index funds, argue that:

• Very few managers consistently beat the market.
• Driven by emotions like fear and greed, investors often make poor buy, sell and investment selection decisions.
• The costs involved in trying to beat the market (research, trading, administration etc) can eat into your return.

Active investors – those who want a manager to chase alpha on their behalf - counter these arguments by saying:

• You can find managers who consistently beat the market.
• Tying your investment return to the market – to beta - means foregoing opportunities to capture extra returns.
• In bear markets – a sustained period of falling share prices such as that between November 2007 and March 2009 - an active manager can protect or even grow your wealth through good investment choices. An index fund leaves you at the mercy of the market.

Some experts argue that there is a place for both active and passive investing, that having both types of fund is a good form of diversification. Others argue that the choice will depend on your own investment situation – your risk profile, age, attitude and investment experience. Whichever approach you choose, understanding the difference between alpha and beta, between active and passive investment, makes you a more informed and intelligent investor.

[1] The fund’s performance is calculated to the 1st of each month, using exit prices. We assume distributions are reinvested and ongoing fees and expenses are deducted, but any entry/contribution fees are not.