Alpha and beta explained with two funds that both made 13%

Beta: how much it moves with the market

Beta compares a fund's moves with its benchmark's. A beta of 1.0 means it has moved in step. 1.2 means about 20% more than the benchmark in both directions; 0.8, 20% less.

If the benchmark rises 10%, a 1.2-beta fund would be expected to rise about 12%; if it falls 10%, to fall about 12%. Our post on beta of equity fund categories shows where real funds sit.

Alpha: the return beyond that

The return you would expect for a given beta is:

expected return = risk-free rate + beta × (market return − risk-free rate)

Alpha = actual return − expected return.

Let the risk-free rate be 6.5% (the rate WealthTicker uses for Sharpe) and the market return be 12%. The market's excess return is 5.5 points.

Two funds, same 13%

Fund X earned 1.55 points more than its risk justified. Fund Y earned what its higher risk would predict, and slightly less. The headline returns are identical; the quality is not. All figures are illustrative.

Cautions

• The benchmark decides everything. Compare against the right index, and a total return one (see TRI vs price index).
• Short periods mislead. Alpha over one good year can be luck; look at three years or more.
• Positive alpha is uncommon. See which categories show it in positive-alpha equity funds by category.

Alpha and beta are a way to ask "was this return earned, or just borrowed from the market's risk?"

This post is educational, not financial advice. The funds and numbers above are made up to show the method.