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What’s it all about, alpha??

Demystifying some of the commonly used measures of investment risk

In this world, nothing can be said to be certain except death and taxes,” said Benjamin Franklin. Everything else is uncertain and therefore involves an element of risk.

Investment risk means different things to different people. It can mean the extent to which capital is potentially at risk in a fund or the degree to which the manager has moved the fund away from the market index. It can even mean the opportunity cost of investing in a fund if more attractive opportunities are available elsewhere.

With due deference to Franklin, however, there is one more thing which could be added to his list of certainties, which is that we are still guilty of looking too closely at performance without looking closely enough at the risks associated with achieving that return.

It is in all our interests to put customers first and ensure they are treated fairly. We believe the onus is firmly with us at Barings, and with all the other manufacturers of investment products, to communicate clearly with investors and their advisers. This includes a proper articulation of the risks associated with investing in a product.

In this spirit, I would like to go through some of the most commonly used measures of risk and try to demystify the technical terms which are used.

One of the most commonly used terms is alpha. It comes from the hedge fund world and simply means the degree to which a fund has outperformed or underperformed the benchmark. This is usually taken to be a simple measure of the skill of the investment manager although this is not necessarily the case.

Alpha can also be used in the sense that it describes the potential rewards available to a manager in a particular market. Where a market is thought to be highly efficient, there may be less potential for investment managers to deliver alpha. The US equity market, for example, is notoriously difficult for active managers to beat.

In the same vein, beta is commonly used to show the portion of the return attributable to the market. It is also used in a second sense, however, and that is how the volatility – or the pattern of performance – of a fund compares with the underlying market.

If the returns from a fund track the returns from the market perfectly, it would have a beta of 1. It would be precisely as volatile as the underlying market, with the characteristics of an index tracker. If, on the other hand, the fund tended to deliver stronger or weaker performance on a regular basis, the beta would be higher. Lower but more steady returns would mean a beta of less than one and the fund could be said to have relatively defensive characteristics, at least when compared with the market it was investing in.

The degree to which the performance of an individual fund can be attributed to the performance of the underlying market is often shown in another measure, known as R2 or R squared. The higher the R squared, the more meaningful is the beta for a particular fund.

Finally, another very commonly used measure of risk which comes up time after time is the information ratio. This is an attempt to gauge the skill of the investment manager in a slightly more scientific way than simply looking at the alpha. It involves taking the annualised relative return for the fund – the outperformance or underperformance relative to the benchmark index – and dividing this by the tracking error. The end figure shows how much value has been added by the investment manager for the risk taken.

Looking at all these various measures of risk, the information ratio is probably the only one, apart from raw alpha itself, where more is almost always better. All the others simply help to provide more information about the way the fund is run.

Having a low standard deviation or tracking error is neither good nor bad. What may be appropriate for one type of fund in one set of market conditions may not be correct for another. Armed with the right tools, however, it is possible to gain a better insight into the way a fund is managed and – importantly – uncover some clues about how it may be likely to perform in the future.

Ian Pascal is marketing director at Baring Asset Management

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