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alternative betaIt’s tough to find a clear definition for “alternative beta.” Investors love to talk about this concept. It has become a hot topic among investors. But most of them publish articles on the subject of why alternative beta is good or bad. Few take the time to explain exactly what it is.

Alternative Beta Defined

So here you go: Alternative beta an investment strategy in which a fund (like a mutual fund, hedge fund or ETF) structures its returns around an unusual index. A typical fund will build itself around traditional benchmarks, such as the S&P 500 or an industry sector. An alternative beta fund will build itself around either atypical benchmarks and risks, or the fund will be built out of alternative investment assets themselves. These which will naturally track an alternative benchmark.

Alternative asset classes include most assets other than equities (stocks) and debt (bonds).

Alpha and Beta

alternative betaFund managers use two basic concepts to structure investments: alpha and beta.

Alpha measures how a specific investment performs relative to its market. If, for example, shares in ABC Co. perform 10% better than the S&P 500 as a whole, investors could measure that performance as ABC Co.’s alpha. It measures an investment’s unsystematic risk; the risk specific to that particular asset.

Beta reflects how much exposure an investment has to general market risk. That “systematic risk” includes changes to the tax code, interest rates or inflation. It does so by measuring the likelihood that the asset will change value and by how much, compared to the market as a whole. An investment’s beta measures how much systematic risk affects a specific asset and, as a result, how closely that asset’s return tracks its specific marketplace.

Alpha measures the difference between the market and an asset’s returns. Beta measures the difference between the market and an asset’s volatility.

For example, say that ABC Co. gets a new CEO and investor confidence causes its stock to rise. That’s “alpha”: A return or risk specific to ABC Co.’s stock. On the other hand, say that ABC Co. also is carrying a lot of debt. As a result, an interest rate increase disproportionately hurts its stock relative to the market at large. That “beta” indicates how ABC Co.’s stock responds to market-wide forces.

Both alpha and beta are expressed as a numeric figure. For example, if a stock returns 10 percent while the S&P 500 returns 3%, its alpha would be 7.

The Alternative Beta Difference

Unlike standard beta, alternative beta is not a measurement. It is an investment strategy built around the concept of beta.

Beta measures how an investment responds to systematic risk. Put another way, it measures how closely that investment’s movement mirrors the movement of a benchmark. It can be used to measure specific assets such as an individual stock or bond, or it can be used to measure the performance of an entire fund.

For example, say that a brokerage built Mutual Fund XYZ and indexed it to the S&P 500. If Mutual Fund XYZ and the S&P 500’s growth was exactly the same, then the fund would be said to have beta 1. This means that there is no difference between the performance of the fund and the performance of its benchmark index.

You’ll notice, however, an important element of our beta measurement: It depends on the benchmark you use. If we had compared Mutual Fund XYZ to the Dow Jones Industrial Average or foreign currencies, we would see a very different beta.

This is the concept behind alternative beta.

Alternative Beta in Use

Funds, such as mutual funds, will often build their portfolios around a specific beta. They want the portfolio to track a given index, such as the technology industry, the bond market or the S&P 500 itself. By selecting this benchmark and then ensuring that they keep the fund’s beta as close to “1” as possible, they can generate consistent returns.

Alternative beta is a strategy in which a fund will choose non-traditional benchmarks by which to measure its success. In some cases this can mean selecting traditional assets, such as stocks and bonds, but building the fund to reflect a different aspect of the marketplace. For example, you could build a mutual fund around the price of gold. Investors may consider this an alternative beta strategy, since it involves precious metals instead of standard benchmarks. The fund could invest in stocks and bonds. But it would try to keep its value consistent with the price of gold in the marketplace.

An alternative beta fund can also build itself out of alternative assets. For example, most mutual funds hold “long” positions, in which they gain value when the price of the asset goes up. An alternative beta fund could instead choose to hold short positions, which gain value when the price of the asset declines. The “alternative” fund’s value benchmark would be the reverse of traditional investment’s. It would seek to track market decreases as closely as possible.

Alternative beta is not a measurement system. This investment strategy built seeks profits in new sections of the market.

The Bottom Line

alternative betaAlternative beta is a fairly new, and increasingly popular, way to build fund-based investments. It involves building a fund around non-traditional benchmarks, allowing your portfolio to reflect entirely different aspects of the marketplace.

Investment Tips

  • Still wondering if alternative beta is right for you and your portfolio? A financial advisor may be able to help. Finding the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in 5 minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.
  • Do you know how much you’ll need to invest to meet your goals? What does your risk tolerance look like? How much will taxes and inflation take out of your investments? If you still don’t know the answer to these initial investment questions, SmartAsset’s investing guide can help.

Photo credit: ©iStock.com/dima_sidelnikov, ©iStock.com/Maximusnd, ©iStock.com/GaudiLab

Eric Reed Eric Reed is a freelance journalist who specializes in economics, policy and global issues, with substantial coverage of finance and personal finance. He has contributed to outlets including The Street, CNBC, Glassdoor and Consumer Reports. Eric’s work focuses on the human impact of abstract issues, emphasizing analytical journalism that helps readers more fully understand their world and their money. He has reported from more than a dozen countries, with datelines that include Sao Paolo, Brazil; Phnom Penh, Cambodia; and Athens, Greece. A former attorney, before becoming a journalist Eric worked in securities litigation and white collar criminal defense with a pro bono specialty in human trafficking issues. He graduated from the University of Michigan Law School and can be found any given Saturday in the fall cheering on his Wolverines.
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