I’m going to write about this in two posts.

Today’s will give some basic background. Tomorrow’s will look at smart beta itself.

alpha and beta

Right after WW II many professional investors, and academics as well, were eager to apply newly emerging computer technology to analyzing the stock market.  Harry Moskowitz, an IBM scientist, was the first.  He suggested using computers to record and analyze the interrelations in price action among all the stocks in the market.  But measuring the reciprocal influences on even relatively small numbers of stocks proved too daunting for the computing machines of the day.

That led to the idea that the task be simplified by not relating each stock in a universe like the S&P 500 to each of the other 499.  Study, instead, how they each behave in relation to some common standard–in fact, relate each to the index itself.  un a regression analysis that correlates the daily price change in each stock with the price change in the index.

An equation showing the results for a stock “y” would be in the form:

y = α + βx + an error term that can be ignored

So the price change “y” for any stock can be broken down into two elements:

—systematic,return, or beta, the portion due to market fluctuations.  For academics, this is a constant “β” derived from the regression, multiplied by “x,” the price change in the market  and,

—a non-systematic term or alpha,, an “extra” return, that can be either positive or negative.

By definition, the β of the market = 1.0 (the sum of all the returns of the market components = the return on the market).

In the strange world of academic financial orthodoxy, it’s impossible to achieve a positive α. The only was investors can achieve a higher return than the market is by arbitrage–by borrowing money and buying what amounts to an index fund.

The popularity of this view–whose only virtue as I see it is its simplicity–shows itself in industry jargon.  Active managers are said to be “seeking alpha.”  Pension plan sponsors routinely separate their equity assets into active and passive, the latter being moneh invested in “safe” index products.

“Smart beta” is a marketing approach by active managers to e a portion of their “safe” index assets to the “seeking alpha” pool.  Apparently they’re successful, although the essence of their pitch is semantic—-they label their active managing activity as being “beta,” not alpha.  It’s the equivalent of the old junk bond pitch, “all the safety of bonds, all the high returns of stocks.”  We all know how that ended.

More tomorrow.