Alpha describes the excess returns a fund can generate relative to the return of a reference benchmark. This benchmark return is called Beta.
Traditionally, these benchmarks were market cap weighted indices, such as the FTSE All Share or S&P 500. Since the 1970's, it has been possible to buy cheap access to them via passive funds.
In recent years, an increasing number of Smart Beta strategies have tried to improve on the market cap weighted benchmark.
By systematically tilting to factors that active fund managers were using to generate Alpha, such as being cheaper, higher quality or smaller than the benchmark.
These strategies can now also be accessed at little cost. This poses a threat to the active fund management industry.
But for fund selectors who research and recommend active managers, Smart Beta represents a superior yardstick to judge them on.
An active fund manager should be able to beat two things:
The traditional market cap benchmark.
The relevant Smart Beta strategy (after costs on both sides).
Otherwise, what is the point in hiring them?
So, True Alpha is this;
The return in excess of both the reference benchmark and the relevant style benchmark.
N.B. "Smart Alpha" refers to the excess returns a quantitative manager can generate over a Smart Beta strategy. For more on that, please download Asset Class.
Let me give you an example…
A UK Equity Income manager should be able to beat the FTSE All Share and a UK High Income ETF. Likewise, a Global Equity manager focusing on the highest quality companies globally should be judged against MSCI World and a Global Low Volatility Smart Beta strategy.
With Smart Beta offerings that provide exposure to Value, Quality, Momentum, Size, Low Volatility and High Dividends, most active strategies now have a better reference benchmark than the old market cap weighted indices.
Fund selectors can place the returns in better context, and focus on the elements of a manager’s process that allow them to produce superior returns to Smart Beta, after the extra costs.
With this mindset, the return pattern of an active fund manager put in a different light tends to seem worse.
For example, several active UK equity funds look great compared to the FTSE All Share, which is dominated by large oil companies and banks.
Compare them to a mid-cap index and, suddenly, what looked like skill is just size beta.
Likewise, Income funds compared to a combination of a High Income and a Low Volatility index, might not look as impressive. On the flip side, comparing a Value manager to a Value benchmark explains why their returns may look poor compared to the market cap benchmark.
Taking this approach will almost certainly make a number of active fund managers ripe for replacing with a cheaper systematic strategy.
Ultimately, they are not doing enough to beat the Smart Beta benchmark after the extra costs they charge.
Schemes can therefore save on fees and focus time and resources on the managers out there capable of delivering True Alpha.