All about alpha, beta, and smart beta

In recent years, investors have poured billions of dollars into so-called "smart beta" investment strategies. As with any investment choice, it's best to understand the concepts behind a particular strategy before investing. So let's examine the theories behind the recent popularity of smart beta strategies.

The performance of the stock market, whether as a whole or as different segments, is measured by stock market indexes. For example, the S&P 500 Index is a widely used measure of overall performance of the US stock market. As its name suggests, this index measures the daily changes among 500 large US corporations, based on their market capitalization.

The term "beta" is simply a measure of a stock's sensitivity to the movement of the overall stock market. The beta of the S&P 500 is expressed as 1.0. The beta of an individual stock is based on how it performs in relation to the index's beta. A stock with a beta of 1.0 indicates that it moves in tandem with the S&P 500.

If a stock's performance has historically been more volatile than the market as a whole, its beta will be higher than 1.0. For example, a stock with a beta of 1.2 is 20% more volatile than the market. So if the S&P 500 rises 10%, a stock with a beta of 1.2 is expected to rise by 12%. Of course, beta works both ways. If the S&P 500 falls 10%, a stock with a beta of 1.2 is expected to fall by 12%. Generally, the higher a stock's beta, the more volatile it is.

While a stock's beta measures its volatility, it does not necessarily predict direction. A stock that performs 50% worse than the S&P 500 in a down market and a stock that performs 50% better than the S&P 500 in an up market will each have a high beta. Therefore, beta is best used for finding companies that tend to track the movements of the S&P 500 (i.e., with betas closer to 1.0).

If you're the type of investor easily rattled by market volatility, you may want to seek out investments with a lower beta. Conversely, if you are seeking potentially higher returns in exchange for higher risk, higher beta stocks might generally be a good match.

Alpha vs. beta

"Alpha" is another common term you'll see when researching investments, particularly mutual funds. Unlike beta, which simply measures volatility, alpha measures a portfolio manager’s ability to outperform a market index. Alpha is a measure of the difference between a portfolio's actual returns and its expected performance, given its level of risk as measured by beta.

For example, if a mutual fund returned 10% in a year in which the S&P 500 rose only 5%, that fund would have a higher alpha. Conversely, if the fund gained 10% in a year when the S&P 500 rose 15%, it would earn a lower alpha. The baseline measure for alpha is zero, which would indicate an investment performed exactly in line with its benchmark index.

Generally, if you were investing in a mutual fund or other type of managed investment product, you would seek out managers with a higher alpha. Keep in mind that both alpha and beta are based on historical data. As every investment prospectus warns, past performance is no guarantee of future results.

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Understanding "smart beta"

As explained above, a stock's sensitivity to movements in the broader market is measured by its beta. By understanding a stock's beta, investors can theoretically build a portfolio that matches their risk tolerance.

In recent years, however, a new approach to index investing—smart beta—has started to gain traction among investors. Smart beta refers to an enhanced indexing strategy that seeks to exploit certain performance factors in an attempt to outperform a benchmark index. In this sense, smart beta differs fundamentally from a traditional passive indexing strategy.

Smart beta strategies also differ from actively managed mutual funds, in which a fund manager chooses among individual stocks or sectors in an effort to beat a benchmark index. Smart beta strategies seek to enhance returns, improve diversification, and reduce risk by investing in customized indexes or ETFs based on one or more predetermined "factors." They aim to outperform, or have less risk than, traditional capitalization-weighted benchmarks but typically have lower expenses than a traditional actively managed fund.

Many traditional index funds and ETFs are "capitalization-weighted." This means that the individual stocks within the index are based on each stock’s total market capitalization. Stocks with higher market capitalizations are weighted more heavily than stocks with lower market capitalizations. As a result, it's possible for a handful of highly valued stocks to represent a large percentage of the index's total value.

Rather than relying solely on market exposure to determine a stock's performance relative to its index, smart beta strategies allocate and rebalance portfolio holdings by relying on one or more factors. A factor is simply an attribute that might help to drive risk or returns, such as quality or size.

For example, stocks of companies that generate superior profits, strong balance sheets, and stable cash flows are considered high quality, and tend to outperform the market over time. Similarly, small-cap stocks have historically outperformed large-cap stocks, although leadership can shift over shorter periods. Most factors are not highly correlated with one another, and different factors may perform well at different times.

If a strategy that blends components of active and passive investing appeals to you, you might want to consider investing in smart beta strategies. Before investing, be sure to read the fund’s prospectus carefully to ensure you understand the risks fully.

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ETFs are subject to market fluctuation and the risks of their underlying investments. ETFs are subject to management fees and other expenses.

Stock markets, especially foreign markets, are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments. Foreign securities are subject to interest rate, currency exchange rate, economic, and political risks. The securities of smaller, less well-known companies can be more volatile than those of larger companies. There is no guarantee that a factor-based investing strategy will enhance performance or reduce risk. Before investing, make sure you understand how the fund’s factor investment strategy may differ from more traditional index products. Depending on market conditions, fund performance may underperform compared to products that seek to track a more traditional index. The return of an index ETF is usually different from that of the index it tracks because of fees, expenses, and tracking error. An ETF may trade at a premium or discount to its Net Asset Value (NAV).

Investing involves risk, including risk of loss.

Beta is a measure of risk. It represents how a security has responded in the past to movements of the securities market. Smart beta represents an alternative investment methodology to typical cap-weighted benchmark investing, and there is no guarantee that a smart beta or factor-based investing strategy will enhance performance or reduce risk.

Past performance is no guarantee of future results.

Diversification and asset allocation do not ensure a profit or guarantee against loss.