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ETF Specialist

Shrinking Alpha

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

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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.

Michael Rawson does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.