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Much work in the current economic literature has focused on die separation of alpha and beta. While alpha can be elusive, considerable effort in the asset management industry is dedicated to active managementthe quest to find and capture excess return. As alpha can be expensive to acquire, it normally commands a fee premium. Hedge fond and private equity managers are renowned for the high fees they charge their investors in the generation of active returns.
Conversely, beta is defined as the efficient capture of risk exposures tied to broad asset classes. Beta represents the systematic risk exposure associated with the equity markets, bond duration, exposure to commodities, credit exposure, and even the systematic returns associated with volatility embedded within stock options. Beta should be acquired cheaply because active management is not necessary to capture the systematic risk premium associated with an asset class.
For the most part, alpha and beta are considered as two points of an economic compass, as diametricaUy opposed as east and west. Generally, beta is considered to be the art of passive portfolio management, whde alpha represents active portfolio management. In fact, economic reality is different. There is a continuum between beta and alpha; starting with classic beta at the one end to pure alpha at the other end. Along this continuum are different forms of beta that recognize the efficiency of risk premium capture, but also acknowledge that one-size beta doesn't fit every investor.
In this article, I define the beta continuum. Beta is not a point estimate; rather, there is a range of risk premium capture that can be described as beta. Note that what is sometimes labeled alpha is really more beta, and belongs along the beta continuum.
I begin by describing classic beta, and then move along the continuum as we get closer to active management.
CLASSIC BETA
Classic beta is the beta we all grew up with. It is the market beta, the broad-based beta, the beta of the capital asset pricing model as defined by Sharpe. Classic beta is typicaUy defined with reference to a broad stock market index such as the S&P 500, the Russell 1000, MSCI-EAFE, the FTSE 100, or the Nikkei 225. These widely based indexes are designed to track the systematic...