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Shrinking Alpha

Common sources of return can now explain performance that was once attributed to skill.

Michael Rawson, CFA, 05/28/2014

Over the past two decades, the share of passively managed equity fund assets has risen. While some lament that passive investors have consigned themselves to merely average returns, the truth is that the average has been pretty good. The return of large-cap U.S. stocks has been about 10% per year on an annualized basis since 1926. This is the baseline upon which we can judge the performance of any U.S.-stock fund. In fact, most of the movement of our funds can be explained by exposure to a broad market index. This is called beta in industry parlance. Any additional return that an active portfolio manager might deliver on top of the average is called alpha. If we graph monthly fund returns on a y-axis versus index returns on the x-axis and then fit a line through the points, what we have is a linear model called the capital asset pricing model, or CAPM. The two terms, alpha and beta, refer to the intercept and slope of the line.

Alpha can be an indication of the unique skills a portfolio manager brought to the table. Active managers that can deliver alpha command higher fees, while beta is often obtained through low-cost passive funds. But alpha can also be a sign that the model is incomplete and failed to capture everything going on in the portfolio. As the science of investing has evolved, researchers have uncovered other common sources of return.

The traditional beta from the CAPM indicates the extent to which a portfolio was exposed to the market. But there are other betas. Any characteristic or attribute of our portfolio that is systematically related to risk or return can be accounted for using this statistical approach. Naturally, we want to look for attributes that are associated with return. Value, size, momentum, liquidity, and quality have been identified historically in the data, and there is some theory that suggests these are not spurious relationships. The table below shows the average monthly excess return for the market along with returns from going long a basket of stocks with high values of the factor and short a basket of stocks with low values of the factor. The data are from Andrea Frazzini. More information about these factors can be found in this article by my colleague, Alex Bryan.

We analyzed all passive and active funds and ETFs in the U.S.-equity category, first using a single-factor model, also called the CAPM, and then with a multifactor model that includes these other factors. In the next table, we show the average monthly return and standard deviation along with median values for the alpha and betas. We also show the R-squared, which tells us the how good the model is at explaining the movements in our portfolio, and the tracking error, which indicates how much movement in the portfolio the model could not explain.

The average monthly return for passive funds was 1.01%, and the average MKT beta was 1.04. Multiplying that beta times the average return to the MKT factor of 0.93 yields 0.97. Adding in the alpha of 0.04 to 0.97 brings us to the average monthly return of 1.01. Thus, exposure to the market beta provided us with 0.97 of our monthly return, while alpha provided just 0.04.

Michael Rawson, CFA is an ETF Analyst with Morningstar.

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