David Nelson

David Nelson

Over 100 years ago, financial markets looked much different than they do today. Then, there wasn’t really a concept of “the market.” There were simply individual stocks to buy and sell. Investment performance was solely determined by investor’s acumen in picking the right stocks to buy. This dynamic prevailed for a long time.

Over time this changed. In the early 1900s, Charles Dow created the Dow Jones Industrial Average, which tracked the performance of a basket of important stocks. This allowed investors to gauge how well the market was doing. Later, in the 1960s, work by William Sharpe and others led to the widespread adoption of the concept of beta.

Beta is essentially a way to quantify the risk of the market in general. All stocks in the market have beta exposure, meaning the overall market return describes some of the performance of the individual stock. This was an extremely important step in the evolution of investing because now, instead of investment performance being entirely explained by the specific stocks selected by an investor, only the performance above or below the market performance is attributable to this stock selection. This performance in excess of the market return is called alpha.

You might be wondering why that is an important distinction. Not long after the widespread use of the beta concept, the first index funds became available. Most people are familiar with mutual funds, which became popular in the U.S. in the 1950s. Initially, mutual funds were run by managers whose job it was to pick the stocks they thought would perform best. Today, we call this active management to denote the active nature of selecting the stocks to hold in the fund. By contrast, index funds are passive in nature. This means that they follow a predetermined set of rules that decides what stocks they will hold. Early index funds largely tracked the market broadly; and these broad market index funds are still the most popular today.

Because they followed simple rules and didn’t require a lot of research and active trading, index funds made gaining access to broad market exposure very inexpensive. This is the reason separating beta (market exposure) from alpha (stock picking skill) is important. Since market exposure is cheap, investors should really only want to pay for alpha.

In the past 10 years or so, the investing evolution has continued. In the years since the advent of beta and alpha, investors have poured enormous amounts of time and money into understanding alpha. This has led to the discovery of performance factors. A factor is simply a set of quantifiable characteristics of a stock that can explain differences in returns. Probably the best-known factor is value; however, there are many that have strong support in academia and the investing community: momentum, size, volatility, and quality to name a few.

These factors were used to break down alpha even further. Now, instead of investment performance being explained solely by market beta and alpha (stock picking skill), some of that alpha has now been ceded to factor exposure.

The last decade has seen an explosion of funds targeted at these factors, to the point where not only is it inexpensive to gain access to broad market exposure, but it is also cheap to gain access to many factor exposures.

For years, money has been coming out of actively managed mutual funds and going into passively managed exchange-traded funds (ETFs). These ETFs have made it easy and cheap to replicate some strategies of popular and successful professional investors. For instance, if a popular investor advocates buying high quality companies that are cheap, the strategy can be replicated with the quality and value factors and implemented using a few ETFs.

This is not to detract from professional money managers who add value through stock picking. It is to say that investors should understand what they are paying for since broad market and factor exposures can be accessed for just a few hundredths of a percent. To a large extent, the seemingly endless availability of products using customized indexes and themes is the new world of stock picking. Investors could definitely benefit by paying attention to these developments.

David M. Nelson is president and CEO of NelsonCorp Wealth Management.

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