Analyzing Investment Performance with Alpha & Beta

Sean P. Gilligan
Author
June 4, 2021
15 min
Analyzing Investment Performance with Alpha & Beta

Alpha and beta provide key insights into whether the active management of an investment strategy is truly adding value or merely adjusting the strategy’s exposure to risk. Understanding alpha and beta can help you assess whether a strategy is outperforming on a risk-adjusted basis.

What is Beta?

Beta measures the sensitivity of a strategy to market movements, which is the most common way to assess the systematic risk of a strategy compared to its benchmark. If the strategy returns move perfectly in sync with the benchmark return, then the strategy’s beta, as compared to that benchmark, is one (i.e., they are perfectly correlated). A beta greater than one means that the strategy is more sensitive (or volatile) than its benchmark while a beta less than one means it is less sensitive (less volatile) than its benchmark. A beta of zero means that the strategy is uncorrelated to the benchmark, while a negative beta means that it is negatively correlated with the benchmark. We will explain this more, but first let’s discuss how it works.

How to Calculate Beta

Beta is calculated as the covariance of the strategy and the market (benchmark) divided by the variance of the market (benchmark).

If every time the benchmark goes up 1%, the strategy goes up 1.2%, and every time the benchmark goes down 1%, the strategy goes down 1.2%, then the beta is 1.2. This means that the portfolio has increased its systematic risk (perhaps through adding leverage, but otherwise replicating the index). In this case, the portfolio manager has increased the strategy’s systematic risk and volatility as compared to the benchmark, but the manager has not “added alpha.” This strategy will outperform on the upside but will underperform on the downside.

Conversely, if every time the benchmark goes up 1%, the strategy goes up 0.8%, and every time the benchmark goes down 1%, the strategy goes down 0.8%, then the beta is 0.8. This means that the portfolio has decreased its systematic risk (perhaps through adding cash, but otherwise replicating the index). In this case, the portfolio manager has decreased the strategy’s systematic risk and volatility as compared to the benchmark and, as a result, the strategy is expected to underperform the benchmark on the upside and outperform on the downside.

Betas can also be negative; in which case the strategy is negatively correlated with the benchmark and would move in the opposite direction. For example, we would expect a strategy with a beta of -0.5 to go down 0.5% for every 1% increase in the benchmark. Betas can also be zero, indicating that the strategy’s movements are uncorrelated with the movements of the benchmark. Market neutral strategies generally strive to have a beta of zero to eliminate systematic risk from the management of the strategy. This is often achieved through a mix of long and short positions.

Beta vs. Standard Deviation

When analyzing performance, there are two types of risk: systematic and unsystematic risk.  Beta is a measure of systematic risk (i.e., market risk) and standard deviation is a measure of total risk. While beta is focused on correlation with the market or the strategy’s benchmark, standard deviation is focused on the variability of returns. This variability is a combination of systematic risk (market risk) and unsystematic risk (company-specific risk).

Both measures can be used in assessing risk-adjusted returns. Beta is used as the denominator in the Treynor Ratio, which measures how much excess return is generated per unit of systematic risk and is used to show the volatility the investment adds to a fully diversified portfolio. Standard deviation is used as the denominator in the Sharpe Ratio, which helps investors understand their returns as compared to the total risk of the portfolio. In contrast with Treynor, Sharpe is often used to compare fully diversified strategies against each other. For more information on systematic risk verses total risk, check out our article on Investment Performance & Risk Statistics.

What is Alpha?

Jensen’s alpha measures how much the strategy outperformed its expected return, with the expected return determined based on the Capital Asset Pricing Model (CAPM).

How to Calculate Alpha

To determine if the portfolio manager has “added alpha,” you can calculate Jensen’s alpha for the strategy. Using CAPM, the expected return is determined by the risk-free rate plus the beta-adjusted benchmark return. Specifically:

Jensen’s Alpha is then determined by subtracting the expected return from the actual return. Specifically:

If the portfolio manager is truly “adding alpha” (through stock selection, over/underweighting sectors, etc.) and not just increasing systematic risk in their active management, then the strategy’s Jensen’s alpha should be positive.

A positive Jensen's Alpha means the manager is consistently beating the market. A negative Jensen's Alpha means the manager is consistently under-performing. Demonstrating positive alpha over a sustained period of time demonstrates to clients and prospects of the strategy that the active investment decisions made by the portfolio manager resulted in an increased return without increasing systematic risk.

It is important to note that Jensen's Alpha is part of a regression and usually is accompanied by t-statistics and p-values to test significance levels. In other words, looking at Alpha without testing for statistical significance should be used with caution. If Alpha is positive but not statistically significant, it may not actually mean the manager outperformed on a risk-adjusted basis.

Why it's Important to Understand Alpha and Beta

Alpha and beta are widely used statistics that help managers of active investment strategies demonstrate their skill. Comparing strategy returns to benchmark returns without accounting for risk will not provide the full picture. Adjusting for systematic risk will help isolate the return achieved from increasing exposure to the market versus the return that is achieved through investment decisions that increased return without increasing systematic risk exposure.

Adjusting for total risk, rather than only for systematic risk is also important when demonstrating skilled active management. As mentioned earlier, check out Longs Peak’s articles on Investment Performance & Risk Statistics as well as the Sharpe Ratio and the Sortino Ratio to learn more about this.

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ColoradoBiz Names Longs Peak’s Jocelyn Gilligan, CFA, CIPM as a GenZYZ Top Young Professional
Longs Peak is pleased to announce that Partner and Co-Founder, Jocelyn Gilligan has been named a GenXYZ Top Young Professional by ColoradoBiz Magazine. As ColoradoBiz states, “They’re uncommon achievers, whether as entrepreneurs, CEOs, nonprofit leaders, visionaries critical to their companies’ success or, in some cases, all of those roles. This year’s Top 25 Young Professionals figure to continue making a difference professionally and in their communities for years to come.”
March 14, 2023
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Longs Peak is pleased to announce that Partner and Co-Founder, Jocelyn Gilligan has been named a GenXYZ Top Young Professional by ColoradoBiz Magazine.

As ColoradoBiz states, “They’re uncommon achievers, whether as entrepreneurs, CEOs, nonprofit leaders, visionaries critical to their companies’ success or, in some cases, all of those roles. This year’s Top 25 Young Professionals figure to continue making a difference professionally and in their communities for years to come.”

Jocelyn grew up in Boulder, CO and graduated from the University of Colorado. She started her career at Ernst & Young in New York City where she worked on their Financial Services Transfer Pricing Team. She transferred with EY to their office in Shanghai and then eventually to Hong Kong. Jocelyn left EY as a Manager and relocated back to Colorado where she and her husband started a family. Soon thereafter, Jocelyn and Sean founded Longs Peak out of a small one-car garage in their home in Longmont, CO. Now running a thriving team of 14, Jocelyn has weathered the ups and downs of entrepreneurship. She credits a lot of their success to their amazing team and the community of entrepreneurs they live near and network with (Longs Peak is an active member of EO (Entrepreneurs Organization)).

Jocelyn is a voting member of the PTO at her children’s school and a member of Women in Investment Performance Measurement, a group recently founded to support women in the investment performance industry.

Please join us in celebrating this year’s ColoradoBiz Top Young Professionals nominees. You can view the complete list of nominees here

About ColoradoBiz’s Top 25 Young Professionals

The 13th annual Gen XYZ awards is open to those under 40 who live and work in Colorado — numbered in the hundreds, making for difficult decisions and conversations among judges, as always. Applications were judged by our editorial board based on career achievement, community engagement and their stories of how they got to where they are now.

About Longs Peak

Longs Peak is a purpose and values-driven company. It is our mission to make investment performance information more transparent and reliable—empowering investors to make better, more informed investment decisions.

At the onset, we were looking to help smaller investment managers by giving them access to professional performance experts and tools typically only available to very large firms. We know that our work enables emerging managers to compete with the big guys and helps facilitate their growth. We strive to be our clients’ most valued outsource partner and to be known for our exceptional client service. We know that providing exceptional client service means that we must first create a culture that lives by the ideals we are trying to create for our clients. A place where incredibly talented individuals are empowered to put their best work into the hands of clients that truly value what we do. As a firm, we recognize that our greatest asset is people – both those we work with and those we work for. We continue to evolve into something that represents the needs of both of these groups and hope someday a GIPS Report is provided to every prospective investor in the world.

SEC Clarifies Marketing Rule: Gross-of-Fee Returns Allowed Under Certain Conditions
The investment management industry has spent significant time grappling with the SEC’s Marketing Rule and the question of whether gross-of-fee returns can be presented without corresponding net-of-fee returns in certain cases. Many firms have invested resources in trying to allocate fees to individual securities and sectors in an effort to comply. However, the SEC has now issued two FAQs (March 19, 2025) that provide much appreciated clarity on extracted performance and portfolio characteristics. The key takeaway? It is possible to present gross-of-fee returns without net-of-fee returns—if certain conditions are met.
March 27, 2025
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The investment management industry has spent significant time grappling with the SEC’s Marketing Rule and the question of whether gross-of-fee returns can be presented without corresponding net-of-fee returns in certain cases. Many firms have invested resources in trying to allocate fees to individual securities and sectors in an effort to comply. However, the SEC has now issued two FAQs (March 19, 2025) that provide much appreciated clarity on extracted performance and portfolio characteristics. The key takeaway? It is possible to present gross-of-fee returns without net-of-fee returns—if certain conditions are met.

Extracted Performance: Gross Returns Can Stand Alone Under Specific Criteria

Investment advisers often present the performance of a single investment or a subset of a portfolio (“extracted performance”) in marketing materials. Historically, the SEC required both gross and net performance to be shown for such extracts. The new guidance provides a pathway for firms to display only gross-of-fee extracted performance, provided the following conditions are met:

  1. The extracted performance must be clearly identified as gross performance.
  2. The advertisement must also present the total portfolio’s gross and net performance in a manner consistent with SEC requirements.
  3. The total portfolio’s performance must be given at least equal prominence to, and facilitate comparison with, the extracted performance.
  4. The total portfolio’s performance must be calculated over a period that includes the entire period of the extracted performance.

If these conditions are satisfied, the SEC staff has indicated they will not recommend enforcement action, even if the extracted performance is presented without corresponding net returns. This is a notable shift, as it allows firms to avoid the complex and often impractical task of allocating fees at the investment or sector level.

Portfolio and Investment Characteristics: Net-of-Fee Not Always Required

Another common industry question has been whether certain portfolio or investment characteristics—such as yield, volatility, Sharpe ratio, sector returns, or attribution analysis—constitute “performance” under the marketing rule, and if so, whether they must be presented net of fees.

The SEC’s latest guidance acknowledges that calculating these characteristics net of fees can be difficult and, in some cases, may lead to misleading results. As a result, the staff has confirmed that firms may present gross characteristics alone, without net characteristics, if they meet the following criteria:

  1. The characteristic must be clearly identified as calculated without the deduction of fees and expenses.
  2. The advertisement must also present the total portfolio’s gross and net performance in a manner consistent with SEC requirements.
  3. The total portfolio’s performance must be given at least equal prominence to, and facilitate comparison with, the gross characteristic.
  4. The total portfolio’s performance must be calculated over a period that includes the entire period of the characteristic being presented.

As with extracted performance, these conditions help ensure that the presentation is not misleading, reducing the risk of enforcement action.

Bottom Line: A Practical Path Forward

This updated SEC guidance provides much-needed flexibility for investment managers, allowing for the presentation of gross-of-fee returns in a compliant manner. Firms that clearly disclose their approach and follow the specified conditions can reduce compliance burdens while still meeting investor protection standards. While this does not eliminate all complexities of the Marketing Rule, it does offer a practical solution that allows for more straightforward and meaningful performance reporting.

For firms navigating these changes, ensuring clear disclosures and maintaining compliance with the general prohibitions of the rule remains critical. Those who align their advertising materials with these guidelines can now confidently use gross-of-fee performance in a way that is both transparent and in compliance with regulatory requirements.

Questions?

If you have questions about calculating or presenting investment performance in a manner that complies with regulatory requirements or industry best practices, we would love to talk to you. Please feel free to email us at hello@longspeakadvisory.com.

New GIPS Standards Guidance for OCIOs: What You Need to Know
The Global Investment Performance Standards (GIPS®) have released a new Guidance Statement for OCIO Portfolios, bringing greater transparency and consistency to the way Outsourced Chief Investment Officers (OCIOs) report performance. This update is a significant milestone for firms managing OCIO Portfolios and asset owners looking to evaluate their OCIO providers.
February 3, 2025
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The Global Investment Performance Standards (GIPS®) have released a new Guidance Statement for OCIO Portfolios, bringing greater transparency and consistency to the way Outsourced Chief Investment Officers (OCIOs) report performance. This update is a significant milestone for firms managing OCIO Portfolios and asset owners looking to evaluate their OCIO providers.

What is an OCIO?

An Outsourced Chief Investment Officer (OCIO) is a third-party fiduciary that provides both strategic investment advice and investment management services to institutional investors such as pension funds, endowments, and foundations. Instead of building an in-house investment team, asset owners delegate investment decisions to an OCIO, which handles everything from strategic planning to portfolio management.

Who Does the New Guidance Apply To?

The Guidance Statement for OCIO Portfolios applies when a firm provides both:

  1. Strategic investment advice, including developing or assessing an asset owner’s strategic asset allocation and investment policy statement.
  2. Investment management services, such as portfolio construction, fund and manager selection, and ongoing management.

This ensures that firms managing OCIO Portfolios follow standardized performance reporting, making it easier for prospective clients to compare OCIO providers.

Who is Exempt from the OCIO Guidance?

The guidance does not apply in the following scenarios:

  • Investment management without strategic advice – If a firm only manages investments without advising on asset allocation or investment policy.
  • Strategic advice without investment management – If a firm provides recommendations but does not manage the portfolio.
  • Partial OCIO portfolios – If a firm only manages a portion of a portfolio, rather than the full OCIO mandate.
  • Retail client portfolios – The guidance is specific to institutional OCIO Portfolios and does not apply to retail investors including larger wealth management portfolios.

Key Change: Required OCIO Composites

Previously, OCIO firms had flexibility in defining their performance composites. Now, the GIPS Standards introduce Required OCIO Composites, which categorize portfolios based on strategic asset allocation.

Types of Required OCIO Composites

  1. Liability-Focused Composites – Designed for portfolios aiming to meet specific liability streams, such as corporate pensions.
  2. Total Return Composites – Focused on capital appreciation, commonly used by endowments and foundations.

Firms must classify OCIO Portfolios based on their strategic allocation, not short-term tactical shifts. This standardization enhances comparability across OCIO providers. The specific allocation ranges for the required composites are as follows:

Required OCIO Composites for OCIO Portfolios

Required OCIO Composites
Source: Guidance Statement for OCIO Portfolios

Performance Calculation & Reporting

To ensure transparency, firms must follow specific rules for return calculations and fee disclosures:

  • Time-weighted returns (TWR) are required, even for portfolios with private equity or real estate holdings.
  • Both gross and net-of-fee returns must be presented to clarify the true cost of OCIO management.
  • Fee schedule disclosures must include all investment management fees, including fees from proprietary funds and third-party placements.

Enhanced Transparency in GIPS Reports

The new guidance also requires OCIO firms to disclose additional portfolio details, such as:

  • Annual asset allocation breakdowns (e.g., growth vs. liability-hedging assets).
  • Private market investment and hedge fund exposures.
  • Portfolio characteristics, such as funding ratios and duration for liability-focused portfolios.

By providing these details, OCIO firms enable prospective clients to make better-informed decisions when selecting an investment partner.

When Do These Changes Take Effect?

The Guidance Statement for OCIO Portfolios is effective December 31, 2025. From this date forward, GIPS Reports for Required OCIO Composites must follow the new standards. However, firms are encouraged to adopt the guidance earlier to improve transparency and reporting consistency.

Why This Matters

With OCIO services growing in popularity, this new guidance ensures that firms adhere to best practices in performance reporting. By establishing clear rules for composite classification, return calculation, and fee disclosure, the guidance empowers asset owners to compare OCIO providers with confidence.

As the December 31, 2025 deadline approaches, OCIO firms should begin aligning their reporting practices with this new guidance to stay ahead of the curve.

Don’t miss CFA Institute’s webinar scheduled for this Thursday February 6, 2025 to hear more on this guidance statement.

Questions?

If you have questions about the Guidance Statement for OCIO Portfolios or the Standards in general, we would love to talk to you. Longs Peak’s professionals have extensive experience helping firms become GIPS compliant as well as helping firms maintain their compliance with the GIPS Standards on an ongoing basis. Please feel free to email us at hello@longspeakadvisory.com.