What is Beta?
This is one of the most staple yardsticks for measuring risk of a stock or a portfolio. If the main objective of portfolio management is earning returns, then the most crucial constraint is risk which can be defined as the standard deviation or volatility of returns. In layman parlance beta could be thought of as the sensitivity of the stock or portfolio to the movement of the entire market of traded securities. Lower the beta value, lower the sensitivity and hence less risky is the investment. Mathematically beta of a stock is derived from historical analysis of the stock returns versus market returns using a statistical tool called regression. A portfolio’s beta is a simple weighted average of the component stocks’ beta in the portfolio. Capital Asset Pricing model(CAPM) theorizes that the excess return of a certain portfolio over and above the risk-free rate is directly proportional to the excess returns of the market as a whole, and in this equation the coefficient of proportionality is ‘beta’.
Before we would go on to understand Jensen’s alpha, it is imperative to get a firm purchase on the conceptual linkage between returns and risk. The plot of values would be a positive sloping curve which goes to show that higher the risk of investments greater would be the returns generated on holding those stocks. With this in the background let us now categorize the returns-earning ability of a fund manager into two parts viz. skill and risk appetite. The part called risk appetite is explained by the phenomenon of beta which propounds that higher the risk loving nature of a fund manager, greater can be the returns he/she generates. However if a fund manager’s mantra is to beat his peers and the benchmark, then skill is what can achieve that desired objective. Jensen’s alpha is that excess return generated by the fund manager over and above what the ‘beta’ of his portfolio would deliver according to the CAPM.
The Sharpe ratios (excess real returns divided by standard deviation of returns) are good, indicating a good risk-adjusted performance i.e. good excess return per unit of volatility. Here volatility is being captured by systematic and unsystematic risk both. Higher the ratio, better the performance of Fund Manager.