Alternative investment managers often explain what they do with the help of two Greek letters, alpha and beta. These are used to describe the two main risks inherent in investing in stocks.
Alpha relates to factors affecting the performance of an individual stock or the managers skill in selecting a particular stock. Whereas, beta relates to market risks, or more specifically, the relative behaviour of stocks.
Beta is therefore a measure of how sensitive the price of a specific stock is to changes in the price of the stock market. Thus a beta-neutral portfolio should be insensitive to swings in the stock market; it would be hedged.
In investment terms, the price fluctuation of a stock is called its volatility. Volatility is regarded as a negative force in an investment portfolio because it affects the stability of returns and increases the risk of a loss of the principal.
Volatility is measured by the standard deviation of a stock or a portfolios return from the mean. Thus, beta is one important measure of volatility.
Ideally, alternative investment strategies will not only minimise downside risk, they will also aim to achieve low levels of volatility.
Many managers perform statistical analysis to rank securities according to their expected returns and risk factors, this is called quantitative risk analysis.
From this analysis, they make judgements on stock selectionto enhance alpha and minimise beta risk. The mathematical analysis is usually performed by computer generated models, earning the epithet black box investing.
To reduce the sensitivity of stocks to market factors and increase their performance, some modern alternative investment managers also use derivative instruments.
On the one hand, derivatives are useful for hedging a portfolio because they allow the manager to set parameters around each investment.
On the other hand, derivatives can also be used to achieve leverage, in order to maximise the alpha of the fund.