Updated 06 May 2022
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This is not substantive investment research or a research recommendation, as it does not constitute substantive research or analysis. This material should be considered as general market commentary.

Alpha
What does it tell you?

Alpha is a measure that tells you by how much a fund manager has outperformed or underperformed their benchmark. A positive alpha means they have outperformed and a negative one means they have underperformed.

Alpha is important to investors as it is a sign of how much they would’ve generated in excess of simply having a passive exposure to an index.

There are different ways of calculating alpha, with one method being more straightforward and the other a little more complex.

How does it work?

Simple alpha
Simple alpha is the simpler method of calculating alpha. It refers to any returns a fund manager generates in excess of those produced by a benchmark index.

For example, imagine an investment trust that is benchmarked against the FTSE 100.

Over a five-year period….

  • The investment trust returns 100%
  • The FTSE 100 returns 90%

In this case, the investment trust’s ‘alpha’ would be 10%.

Jensen’s alpha
There is a more complicated way of calculating alpha known as ‘Jensen’s measure’ or ‘Jensen’s alpha’.

This also looks at a trust’s level of outperformance but includes in its calculation the level of risk the trust managers took in order to achieve it.

Investors may want to look at this information as a way of differentiating between two ostensibly similar investment trusts.

For instance, if you have two investment trusts that both return 100% over five years, you may want to look at how much risk they took on to produce that return. The trust that took on a lower level of risk to produce those returns may appeal more to investors than one which took on lots of risk to do the same.

Even if not used to compare different investment trusts, Jensen’s measure might be used to evaluate a trust by looking at how much risk it takes on to realise returns.

To calculate Jensen’s alpha, you use the following equation:

Jensen’s Alpha = Rp – [rf + β × (Rm – rf)]

Rp = portfolio return

rf = risk free rate

β = beta, a measure of how volatile the portfolio was

Rm = benchmark index return

As with other financial statistics, it’s worth keeping in mind that Jensen’s alpha is not a catch-all solution to evaluating the best investment trusts. For instance, a trust may have taken on low risk and managed to produce high returns over one period of time but then fail to do so in the years ahead.

As such, Jensen’s alpha should be looked at in conjunction with other factors, and not be seen as the only factor driving investment decisions.

Beta
What does it tell you?

Beta is a measure of relative volatility or risk; it shows you how varied a trust’s returns have been relative to a benchmark. The higher the number, the more the trust’s share price has moved when the underlying benchmark has moved. A very low number equates to a negative correlation to the same benchmark.

How does it work?

An investment trust’s beta refers to how volatile it has been relative to the wider market.

The market is seen as having a beta of 1.

An investment trust with a beta of more than 1 means it has a portfolio that is more volatile than the market.

An investment trust with a beta of less than 1 would be seen as being less volatile than the market.

Investors may look at beta to get an idea of how volatile a portfolio is and how much risk it takes on in order to generate the returns it does.

Again, like many financial statistics, this has the potential to be misleading as prior volatility could say very little about future volatility. Moreover, the beta may not say a huge amount about the underlying portfolio or how suitable it is for you as an investor.

As such, the best thing to do is to see beta as one statistic among many that can be used to make investment decisions, rather than being a definitive one.

R-squared
What is it?

This measure shows you how closely correlated to a benchmark a portfolio is. A portfolio with a high r-squared is more likely to move in line with the benchmark than a low one.

R-squared may be used to work out how active an approach a portfolio manager takes to the market. It can also be used to estimate how likely a portfolio is to move in line with the market during periods of volatility.

How does it work?

When used in reference to investment trusts, r-squared generally means looking at how much of a portfolio’s price movements are in line with movements in its benchmark index.

It is expressed as a percentage and the higher the percentage is, the more the portfolio’s movements fit with those of its underlying benchmark.

For instance, an investment trust that invests in large UK companies might have the FTSE 100 as its benchmark.

If that trust had an r-squared of 50%, then half of its movements would be in line with the benchmark.

The reason investors might be interested in this is to get an idea of how active the trust is. A highly active trust is likely to have a lower r-squared, with the potential for outperformance of its benchmark.

The reverse is also true and an investment trust that has a higher r-squared may struggle to outperform its benchmark as it will tend to move in price with it.

Past performance is not a reliable indicator of future results

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