Alpha-Beta Separation and Active Manager Cost

According to Alpha-Beta Separation Theory, the source of returns for any investment portfolio can be separated into market generated Beta and investor generated Alpha. Beta is typically explained as the return generated naturally by the markets due to overall the risk in a market. Alpha is the excess return over Beta due to manager skill or luck. Many investment firms charge for Alpha yet have difficulty delivering Beta.

Commoditized beta is an industry term used to describe other risks in the markets that produce return premiums, such as value premiums and size premiums (See Fama-French Three Factor Model). Commoditized Beta returns reflecting the risks of value and small cap stocks are available at very low cost through index funds, exchange-traded funds, and asset class funds offered by companies such as Dimensional Fund Advisors (DFA).

Alpha is measured as excess portfolio return not explained by market Beta or commoditized Betas. Alpha is attributed to the skill or luck of the investor, whether that investor is an individual or an investment manager. Typically, there is no Alpha in active management after adjusting for all Betas and the extra management cost. Nevertheless, active managers routinely call commoditized Beta as Alpha. In fact, most investors are paying active managers a hefty sum to deliver returns less than those available to investors through a diversified portfolio of Beta products.

From 2000 to 2006, value stocks outperformed growth stocks. As such, value stock heavy active funds outperformed general market index funds that held both value stocks and growth stocks. Value stock managers lauded the performance of their funds in relation to broad market indexes and inferred that they had investment skill. However, upon closer inspection, when a proper benchmark was selected, most of those value managers underperformed a passive index of value stock. Beta was being misinterpreted as Alpha.

Investing in commoditized Beta strategies has become easier and cheaper over the past decade. Any investor can buy a value stock index fund or a small stock index fund or some other type of commoditized Beta fund at a very low fee. It is not necessary to hire an active stock manager to realize these Betas. 

Portfolio Solutions is a Beta seeker. Our mission is to find commoditized Beta products and form portfolios based an efficient allocation of those Betas. We believe that investors are best served with a broadly diversified portfolio of low-cost index funds, ETFs, and other Beta seeking asset class funds. Our strategy greatly reduces investing costs, and that enhances portfolio return over an active strategy. Trying to add Alpha is very costly and unnecessary.  Investors do not need to ‘beat the market’ to meet their financial objectives.