Active investing is a strategy where the investor tries to outperform the market by actively buying and selling securities based on specific metrics. Personally, I prefer passive investing due to a higher holding period return and a more relaxed trading experience that is more long term. However, here are some active investing metrics that can be used to maximize returns.
Alpha
Alpha is a performance metric that represents the excess return of an investment relative to the expected return as predicted by the Capital Asset Pricing Model (CAPM). This metric determines whether an investment can ‘beat the market’ or not. A positive alpha indicates that an investment has outperformed its market-adjusted expected returns. Alpha is calculated as the difference between the actual return of the portfolio (Rp) and its expected return based on market risk, which is calculated using CAPM:
Alpha (⍺) = Rp – CAPM
CAPM = Rf + β(Rm – Rf)
Rp = Actual Portfolio Return
Rf = Risk-Free Rate
β = Beta
Rm = Market Return
Here is an example of how excess returns are calculated: An investment portfolio has returned 15% in the past year. If the risk-free rate is 2% and the market benchmark return (S&P500) is 10%, and the portfolio beta is 1.3. Has this portfolio’s return exceeded the market return?
Expected Return / CAPM = 2% + 1.3(10% – 2%) = 12.40%
Alpha = 15% – 12.40% = 2.6%
Therefore, we can determine that the positive alpha of 2.6% means the portfolio has outperformed the market.
CAPM provides an expected rate of return based on systematic risk, which serves as the benchmark to determine if an excess return, or alpha, is generated by the actual investment performance relative to this expected return.
Beta
Beta is a statistical measure that determines the volatility and correlation of an asset compared to the rest of the market. Like we discussed above, beta is a component of the Capital Asset Pricing Model since the beta is the systematic risk that is accounted for when calculating expected return. A beta of 1 represents the market (S&P500) and a beta above 1 means the stock is more volatile than the market and has a strong positive correlation to market movements. A beta of less than 1 means the stock is less volatile and represents a weaker correlation.
Active investors can utilize beta to manage risk, and leverage market movements for higher returns. For example, mixing low-beta stocks into a portfolio with high-beta stocks can act as a buffer against extreme losses. Additionally, active investors can make the best out of bullish and bearish systematic market trends to fill the portfolio with high-beta stocks during the bull market and low-beta stocks during the bear market.
Sharpe Ratio
Sharpe ratio is a metric that allows investors to assess the performance of an investment relative to its risk. For example, investors can measure how much excess return they are receiving for the extra volatility they are enduring from investing in a riskier asset. The Sharpe ratio accounts for the portfolio return, the risk free rate, and the standard deviation in a formula as follows:
(Rp – Rf) / σp
Rp = Actual Portfolio Return
Rf = Risk-Free Rate
σp = Standard Deviation of Excess Returns
I will not delve too deep into the relationship standard deviation has in active investing, but it basically measures how much an asset’s return will vary from the average return. The higher the Sharpe ratio is, the higher the portfolio return is for each unit of risk taken. Active investors can utilize Sharpe ratio for portfolio optimization. This is the strategy of adjusting the weightage of each asset in a portfolio to achieve the highest return with the lowest risk. For example, an investor can pick a handful of stocks in different sectors and can choose to invest $100k overall for all these assets. Optimizing this portfolio would involve investing more money in certain assets and less in others so it is weighted according to highest return and lowest risk.