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Alpha, Beta, and Now … Gamma

Measuring the importance of intelligent financial planning decisions.

David Blanchett, CFA and Paul Kaplan, 12/18/2012

This article originally appeared in the December/January 2013 issue of MorningstarAdvisor magazine.  To subscribe, please call 1-800-384-4000. 

The benefits from “good” financial-planning decisions are difficult to quantify. For any given portfolio, investment decisions generally can be decomposed into two primary components: beta and alpha. Beta can be defined as the systematic risk exposures of the portfolio (usually achieved through asset allocation), and alpha is the residual (skill or luck-based) component associated with the various flavors of active management, such as tactical asset allocation, security selection, and more. Alpha and beta are at the heart of traditional performance analysis; however, their impact on a successful retirement can be far less important than other financial- planning decisions.

In this article, we introduce a concept called “Gamma,” which is designed to measure the additional expected retirement income achieved by an individual investor making intelligent financial-planning decisions. Gamma is the third letter in the Greek alphabet (preceded by alpha and beta), and within financial economics, it is sometimes used as the variable denoting an investor’s degree of risk aversion. Given that Gamma is relatively unclaimed within financial literature, we seek to give it new meaning.

Gamma varies for different investors as well as for investors in different lifecycles (for example, the accumulation stage versus retirement). For those who find it hard to break from traditional (and inadequate) performance measurements, Gamma is a metric that is somewhat comparable to alpha, or excess return, but even more than that, it is the return that an investor experiences based on optimal financial decision-making.

In calculating Gamma, we focus on five important financial-planning decisions and techniques: a total wealth framework to determine the optimal asset allocation, a dynamic withdrawal strategy, the incorporation of guaranteed income products, tax-efficient allocation decisions, and a portfolio optimization that includes liabilities.

Each of these five Gamma components creates value for retirees, and when combined, they can be expected to generate 29% more income on a utility-adjusted basis when compared with a simplistic static withdrawal strategy, according to our analysis. This additional income is equivalent to an arithmetic “alpha” (the Gamma equivalent alpha) of 1.82% and thereby represents the potential of a significant increase in portfolio efficiency (and retirement income) for retirees.

Alpha and Beta: Defining Value
The notions of beta and, in particular, alpha have long fascinated financial advisors and their clients. Alpha allows a financial advisor to demonstrate the excess returns generated in an investment portfolio, which can help justify fees. In contrast, beta helps explain the risk factors of a portfolio relative to the market (that is, the asset allocation).

If an advisor is paid solely to manage a portfolio of assets and offers no additional advice regarding anything other than the investment of the client assets, the concepts of alpha and beta should be good measures of the advisor’s value. However, in a more-complex engagement in which the advisor provides financial-planning services to clients, value cannot be defined in such simple terms as alpha and beta because the objective of an individual investor is typically to achieve a goal, and that goal is most likely saving for retirement.

David Blanchett, CFA is Director of Retirement Research with Morningstar Investment Management.  

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