I'm feeling pretty smart. I've made all the investment decisions for my 401K and IRA retirement accounts and, in all immodesty, they appear to have been pretty good ones. Of course, I looked awfully dumb in the fall of 2008 when the bottom fell out of the market and my holdings dropped 50 percent.
So what kind of an investor am I, smart or dumb? Truth be told, the answer is neither: I was simply in the market when it dramatically fell and have remained in as it's steadily returned. I sit passively as it takes me for a ride; I'm just “there.” The good news is that historically the market goes up more than it goes down, so “being there” is generally a good thing.
The portfolio management sub-discipline of performance measurement, in its efforts to quantify the contributions of money managers, distinguishes at least two components of performance. The first is beta, which is based on an index measure of the overall level of the stock market. Think the Dow Jones Industrial Average that you hear on the news each day, though the Wilshire 5000 is the superior measure generally used.
Beta measures how closely a given portfolio tracks overall market performance. A value near 1 indicates a close positive correspondence; a value of -1 indicates the portfolio and the overall market are moving in opposite directions; and a value near zero connotes little if any relationship. If the Wilshire index is generally advancing, most stock portfolios should be up as well; if it's declining, many portfolios will follow.
Since my IRA and 401K funds closely track the Wilshire by design, they move in lock step with the index. For the first year or so of the recession, my holdings declined dramatically in synch with the index. During the past year and a half, they've increased for the same reason. Alas, there's been no skill on my part to produce either gains or loses. I'm simply on a tumultuous ride with the market.
A second measure, alpha, is generally considered the smoking pistol of manager performance. If you think of beta as the slope of a linear regression of over-time portfolio returns on the Wilshire index, then alpha is the intercept. Alpha=0 suggests a portfolio that behaves suspiciously like what would come from beta alone. An alpha<0 hints at a portfolio that under-performs the simple index. Alpha>0 suggests that the portfolio, and hence the manager, is adding value. As a savvy consumer, one should only pay high fees to managers who have positive alpha – who deliver more than the beta of simply being in the market. I'm certainly not happy paying a manager for lower returns than I could get with a less expensive index fund.
Portfolio performance measurement, alpha and beta came to mind when I read an article the other day on 2010 compensation entitled “The Drought is Over (at Least for C.E.O.'s)” in the New York Times. The article highlighted CEO compensation packages that over the last year returned to pre-recessionary levels. “After two relatively lean years, C.E.O'.s in finance, technology, energy and beyond are pulling down multimillion-dollar paychecks. What many of these executives aren't doing, however, is hiring.”
A quick calculation suggests that the Wilshire 5000 is up almost 60 percent over the last year and a half. Are these CEOs deftly guiding their companies or simply the beneficiaries of tracking the market upswing that lifts most boats? To a large extent, I think the latter. “Many businesses were hit so hard by the recession that even small improvements in sales and profits look good by comparison.”
It'd be interesting to know how stock performance of the generous companies compares to the overall market. Is significant compensation being awarded to top execs whose company performance simply mimics the larger market? Is at least part of their pay given for just “being there”?
At least one compensation expert suggests as much: “'What's funny about pay is that when the market is going up, it covers a lot of sins', said David F. Larcker, director of the corporate governance research program at the Stanford Business School. It is when the market 'is going sideways or down that funny things happen,' he said: Considering some of the current pay packages, shareholders want to see strong results.'”
Count me in with the demanding skeptics. I'd certainly want to disentangle alpha from beta before I wrote the big compensation checks. If a CEO can demonstrate significant shareholder benefit – alpha – over the simple “being there” of a positive beta return, I'm OK with the high compensation. But show me the proof first.
Alpha and beta are useful performance measurement metaphors also relevant for BI. Indeed, I always ask the business if alpha and beta should be distinguished in performance measurement during requirements analysis. Most customers answer yes.