The performance letters

A fund gained fifteen per cent this year. Well done? Not so fast. First you need to know what the market did.

To judge a manager, finance uses other letters. The performance letters.

First, beta: how much the fund moves when the market moves.

A beta of one: the fund follows the market. A beta of two: it moves twice as much. A beta of a half: half as much.

Say a fund with a beta of one point two. The market rises ten per cent. You expect twelve per cent from the fund.

The market falls ten per cent? You expect minus twelve. Beta works both ways.

Next, alpha: what the market does not explain. What remains once beta is taken out.

Our fund made fifteen per cent. The market explained twelve. Alpha, put simply, is three points.

Those three points are what the manager claims to add. It is for them that you pay fees.

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But if the market had made twenty per cent, you would expect twenty-four. The same fifteen then gives an alpha of minus nine points.

Next, R squared. It says what share of the fund's moves is explained by the market.

An R squared of ninety-five per cent: the fund is almost the market. An index fund is very close to one hundred.

A low R squared: the fund lives its own life. Then its beta, and so its alpha, say little.

An expensive fund with an R squared close to one hundred often sells you the market, at the price of talent.

Last trap: smoothed beta. It affects assets that rarely trade.

Unlisted property, unlisted companies: their price is not set every day by a market, but by estimates.

Estimates follow the market late, and in small steps. The price looks calm. It is only slow.

Say a market drops twenty per cent in one go. The estimated fund shows minus five per cent, four quarters in a row.

In total, about minus eighteen point five per cent. Almost the same loss. But spread out, it looks well-behaved.

Measured this way, beta and volatility look low. It is not less risk. It is a badly photographed risk.

In nineteen seventy-nine, the economist Elroy Dimson proposed a correction: also take account of the market's past moves.

With this kind of correction, these assets' beta often rises. The calm was partly an optical illusion.

Remember the order of the questions. What beta? What R squared? And only then: what alpha?

A performance alone says nothing. It is performance compared with the risk taken that tells the story.