Often when looking at a fund managers performance you’ll see three stats, the Alpha, the Beta and the Sharpe Ratio. Here’s the short definition of each:

Alpha – is the measurement of a fund’s actual return and its expected return given its beta. Alpha  is the excess return given the risk taken.

Beta – the beta (β) of a stock or portfolio is a number describing the relation of its returns with that of the financial market as a whole.

Sharpe Ratio – is a measure of the excess return (or Risk Premium) per unit of risk in an investment asset or a trading strategy.

When selecting an investment adviser, hedge fund or some other form of money manager, take the time analyze their track record to ensure they are actually giving you an edge.

The most important indicator of the three is the Sharpe Ratio, the higher the better. To give you an idea of a bench mark, the long term Sharp Ratio for the US Market is 0.40625 (based on a long term return of 10% for the market, a 16% Standard Deviation and a 3.5% rate of risk less return). Therefore, if a fund manager has a rating any lower than that, you may be better off just buying the S&P Index.

Beta shows correlation with the market. For instance, a Beta of 1 means that if the market went up 10% above the risk free rate, then the managers portfolio went up 10% after the risk free rate. A Beta of -1 would conversely mean that with a market up 10% above the risk free rate, the managers portfolio went down 10%. It is also possible to have greater than 1 and -1 Beta’s using leverage.

When looking at Beta’s keep in mind what your other asset holdings are. If you already have a substantial amount of money tied up in securities that are heavily correlated with the overall market, you may want to consider hedging that position with a portfolio manager with a negative Beta, but a good Sharpe Ratio.

And in finally, Alpha, which is an indicator of risk compared to reward.  Alpha less than 0 indicates an investment earned too little considering the risk taken, an Alpha equal to 0 indicates an investment earned a return adequate to the risk taken, and an Alpha of greater than 0 indicates a return that was in excess of the risk taken. Keep in mind, that a money manager can have a great year, but if he took excess risk to do so he can still have an Alpha of < 0.

One note of caution, ensure that when you are reviewing a fund managers returns that they are comparing themselves to the appropriate benchmark, such as the S&P 500, the Dow Jones Industrial Average, or in Canada the S&P TSX Composite Index. Those are the benchmarks of the industry.

In addition, if you’re looking for further reading on either of those three metrics checkout the links below.

http://en.wikipedia.org/wiki/Alpha_%28finance%29

http://en.wikipedia.org/wiki/Beta_%28finance%29

http://en.wikipedia.org/wiki/Sharpe_ratio

“A creative man is motivated by the desire to achieve, not by the desire to beat others.

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