What Is Annualization?

To annualize a number means to convert a short-term calculation or rate into an annual rate. Typically, an investment that yields a short-term rate of return is annualized to determine an annual rate of return, which may also include compounding or reinvestment of interest and dividends. It helps to annualize a rate of return to better compare the performance of one security versus another.

Annualization is a similar concept to reporting financial figures on an annual basis.

Understanding Annualization

When a number is annualized, it’s usually for rates of less than one year in duration. If the yield being considered is subject to compounding, annualization will also account for the effects of compounding. Annualizing can be used to determine the financial performance of an asset, security, or company.

When a number is annualized, the short-term performance or result is used to forecast the performance for the next twelve months or one year. Below are a few of the most common examples of when annualizing is utilized.

Company Performance

An annualized return is similar to a run rate, which refers to the financial performance of a company based on current financial information as a predictor of future performance. The run rate functions as an extrapolation of current financial performance and assumes that current conditions will continue.

Loans

The annualized cost of loan products is often expressed as an annual percentage rate (APR). The APR considers every cost associated with the loan, such as interest and origination fees, and converts the total of these costs to an annual rate that is a percentage of the amount borrowed.

Loan rates for short-term borrowings can be annualized as well. Loan products including payday loans and title loans, charge a flat finance fee such as $15 or $20 to borrow a nominal amount for a few weeks to a month. On the surface, the $20 fee for one month doesn’t appear to be exorbitant. However, annualizing the number equates to $240 and could be extremely large relative to the loan amount.

Tax Purposes

Taxpayers annualize by converting a tax period of less than one year into an annual period. The conversion helps wage earners establish an effective tax plan and manage any tax implications.

For example, taxpayers can multiply their monthly income by 12 months to determine their annualized income. Annualizing income can help taxpayers estimate their effective tax rate based on the calculation and can be helpful in budgeting their quarterly taxes.

Example: Investments

Investments are annualized frequently. Let’s say a stock returned 1% in one month in capital gains on a simple (not compounding) basis. The annualized rate of return would be equal to 12% because there are 12 months in one year. In other words, you multiply the shorter-term rate of return by the number of periods that make up one year. A monthly return would be multiplied by 12 months.

However, let’s say an investment returned 1% in one week. To annualize the return, we’d multiply the 1% by the number of weeks in one year or 52 weeks. The annualized return would be 52%.

Quarterly rates of return are often annualized for comparative purposes. A stock or bond might return 5% in Q1. We could annualize the return by multiplying 5% by the number of periods or quarters in a year. The investment would have an annualized return of 20% because there are four quarters in one year or (5% * 4 = 20%).

Special Considerations and Limitations of Annualizing

The annualized rate of return or forecast is not guaranteed and can change due to outside factors and market conditions. Consider an investment that returns 1% in one month; the security would return 12% on an annualized basis. However, the annualized return of a stock cannot be forecasted with a high degree of certainty using the stock’s short-term performance.

There are many factors that could impact a stock’s price throughout the year such as market volatility, the company’s financial performance, and macroeconomic conditions. As a result, fluctuations in the stock price would make the original annualized forecast incorrect. For example, a stock might return 1% in month one and return -3% the following month.

What Is an Agent?

An agent, in legal terminology, is a person who has been legally empowered to act on behalf of another person or an entity. An agent may be employed to represent a client in negotiations and other dealings with third parties. The agent may be given decision-making authority.

Two common types of agents are attorneys, who represent their clients in legal matters, and stockbrokers, who are hired by investors to make investment decisions for them. The person represented by the agent in these scenarios is called the principal. In finance, it refers to a fiduciary relationship in which an agent is authorized to perform transactions on behalf of the client and in their best interest.

Understanding an Agent

An agent is someone that is given permission (either explicitly or assumed) to act on an individual’s behalf and may do so in a variety of capacities. This could include selling a home, executing a will, managing a sports career, managing an acting career, being a business representative, and so on.

Agents often have expertise in a specific industry and are more knowledgeable about that industry’s ins and outs than the average person. For example, if you started gaining attention as a musician, you would hire a music agent to help guide you through getting a record deal, signing record contracts, and arranging your touring schedule.

As you would not have any experience with the record industry, you would need an agent to look out for your best interests and take care of a lot of the work that you would otherwise most likely not be able to complete on your own. This would also free up your time so that you can concentrate on making music.

Types of Agents

Agents come in all types depending on their function and the industry in which they operate. In general, there are three types of agents: universal agents, general agents, and special agents.

Universal Agents

Universal agents have a broad mandate to act on behalf of their clients. Often these agents have been given power of attorney for a client, which gives them considerable authority to represent a client in legal proceedings. They may also be authorized to make financial transactions on behalf of their clients.

General Agents

General agents are contracted to represent their clients in specific types of transactions or proceedings over a set period. They have broad authority to act but in a limited sphere. A talent agent for an actor would fall under this category.

Special Agents

Special agents are authorized to make a single transaction or a series of transactions within a limited period. This is the type of agent most people use from time to time. A real estate agent, securities agent, insurance agent, and travel agent are all special agents.

Uses of Agents

People hire agents to perform tasks that they lack the time or expertise to do for themselves. Investors hire stockbrokers to act as middlemen between them and the stock market. Athletes and actors hire agents to negotiate contracts on their behalf because the agents are typically more familiar with industry norms and have a better idea of how to position their clients.

More commonly, prospective homeowners use agents as middlemen, relying on the professional’s greater skills at negotiation.

Businesses often hire agents to represent them in a particular venture or negotiation, relying on the agents’ superior skills, contacts, or background information to complete deals.

Loyalty Responsibilities of an Agent

Duty of Avoiding Material Benefit

During the course of business, an agent may benefit. This is especially true when an agent is paid to perform a task on behalf of the principal. For example, a real estate agent commonly receives a commission for their work in selling a house.

When acting on behalf of another, an agent must ensure they do not unjustly benefit from their agency position. This includes receiving large benefits from the relationship or taking advantage of their position to ensure they receive benefits that would not normally as part of a normal transaction.

Duty Not to Usurp

When an agent acts on behalf of a principal, the agent may receive information it would be able to personally capitalize on for personal benefit. For example, an agent may receive information relating to a potential investment opportunity. The agent owes the principal the duty to not steal or supplant the principal’s ability to transact. In this example, the principal retains the right to decide whether or not to invest; the agent must not take the place of the principal without the principal explicitly declining an opportunity to invest.

Duty to Not Compete

On a similar note, an agent may not enter into transactions or business that compete with a principal. This conflict of interest puts the principal at a disadvantage as the agent may obtain trade or business secrets during the course of the business relationship. For example, imagine if an agent was tasked with shipping specific goods to an agent’s manufacturing warehouse. The agent could obtain information related to the principal’s operations that the agent could then use for its personal benefit.

Duty of Transparency

Formalized agent-principal arrangements often include verbiage that the agent must disclose if it has any other principals in which it is acting as an agent for. This includes disclosing a sworn statement that the agent will act in good faith across all principals and will incur fair dealing with each principal.

Duty to Protect Information

During the course of an agent’s relationship with the principal, the agent may not disclose confidential information to unrelated parties. This may defined through confidentiality agreements or may not be explicitly called out. In either case, the agent must take care to evaluate the sensitivity of information and the necessity for other parties to obtain that information. This includes not using confidential information for the personal benefit of the agent (i.e. exchanging the information for personal benefit to an independent third party).

Performance Responsibilities of an Agent

Duty of Contract

All terms of any written agreement between an agent and a principal define the relationship between the two. For many agent and principal relationships, the contract is not explicitly defined upfront. However, custom or deliberate agreements may call for very specific terms that define what is and isn’t allowed.

Duty of Care

An agent is always tasked with acting with care and competence when handling affairs of the principal. The standard is often held that the agent must act as the principal would, using discretion as if it would incurring the personal gain or loss. Though the level of care may not be explicitly defined, the level of care should be equal to what is reasonably expected by local standards.

The duty of care may be complicated when considering the agent’s personal benefit potential. For example, consider a broker that receives a commission for the sale of certain investment products. For some clients, it may not be in their best interest to buy those investments. Therefore, the broker has the duty of care to not sell such products to those individuals, sacrificing personal gain to uphold the sanctity of the relationship.

Duty of Obedience

An agent must comply with reasonable instruction. Though there may be situations where acting on one’s behalf and following their guidance is not reasonable or legal, the agent may have recourse to not follow instruction. Otherwise, the agent is bound to perform tasks as expected by the agreement. This includes situations where the principal may be disadvantaged but has instructed the agent to act in a specific manner.

Duty of Disclosure

As the agent gains sensitive information that may influence the decision-making process of a principal, the agent has the duty to disclose that information in an accurate, timely manner. Consider the example of Los Angeles Dodgers’ player Freddie Freeman. Freeman’s agent reportedly did not disclose to Freeman that his former team, the Atlanta Braves, wanted to re-sign him. By withholding such information, Freeman reluctantly signed with a different team.

Duty of Separation

An agent also has the responsibility to keep the agent’s and the principal’s affairs separately. This includes ensuring that any transactions entered into on behalf of the principal are still legal property of the principal. This also ensures that any resources or capital used to transact are maintained in separate bank accounts and that separate reporting ledgers are maintained.

Agent Liability

An agent is often liable to their principal if they violate their duty or deviate from a reasonable, expected action performed on behalf of the other party. This may be the result of exceeding the authority they’ve been given, acting in misconduct, being unreasonably negligent, or any other situation where the principal may incur a loss that could have potentially been avoided.

In some situations when the agent performs a task for another without disclosing they are an agent, they may be considered liable because the agent was presumed to be a principal. An agent is also commonly liable when the agent expressly incurs a personal liability by entering into an associated agreement.

Agency by Necessity

There is also “agency by necessity,” in which an agent is appointed to act on behalf of a client who is physically or mentally incapable of making a decision. This is not always a case of incapacitation. Business owners, for example, might designate agents to handle unexpected issues that occur in their absence. For example, if a CEO was on a flight and unreachable yet an emergency business decision needed to be made, agency by necessity could be used.

Agency by necessity is most often executed in times of emergency or urgency when the primary party is not available to make a decision. In these situations, courts would recognize a third party making the decision if that party was given power by the primary party to do so. The third party would be responsible for acting in the primary party’s best interest.

Estate planning often sees agency by necessity. Though an individual may have created a will outlining how an estate should be disbursed at their time of death, there could be situations where the person became incapacitated before needed adjustments to the will were made. Here, agency by necessity could be used by a trusted party.

The Bottom Line

An agent is anyone that has been entrusted to act on behalf of another individual. People usually call upon an agent when they need someone with more expertise or when they don’t have the time to complete a task.

Agents are commonly used in the finance, law, real estate, insurance, acting, and music industries, yet they can be found in almost any situation when advanced knowledge on a topic is needed. Agents can save people a lot of time, money, and headaches in getting important tasks done.

What Is Aggregation?

Aggregation in the futures markets is a process that combines of all futures positions owned or controlled by a single trader or group of traders into one aggregate position. Aggregation in a financial planning sense, however, is a time-saving accounting method that consolidates an individual’s financial data from various institutions.

Aggregation is increasingly popular with advisors when servicing clients’ accounts, as they are able to discuss the accounts with the client in a cleaner, more easily understood way before they break down the account into its respective categories.

How Aggregation Works

Financial advisors use account-aggregation technology to gather position and transaction information from investors’ retail accounts held at other financial institutions. Aggregators provide investors and their advisors with a centralized view of the investor’s complete financial situation, including daily updates.

Financial planners handle both managed and non-managed accounts. Managed accounts contain assets under the advisor’s control that are held by the advisor’s custodian. The planners utilize portfolio management and reporting software to capture a client’s data through a direct link from the custodian. It is important for the planner to have all the accounts because aggregating them without the complete collection would paint an inaccurate picture of that client’s finances.

Additionally, non-managed accounts contain assets that are not under the advisor’s management but are nevertheless important to the client’s financial plan. Examples include 401(k) accounts, personal checking or savings accounts, pensions, and credit card accounts.

The advisor’s concern with managed accounts is lack of accessibility when the client does not provide log-in information. Advisors cannot offer an all-encompassing approach to financial planning and asset management without daily updates on non-managed accounts.

Importance of Account Aggregation

Account aggregation services solve the issue by providing a convenient method for obtaining current position and transaction information about accounts held at most retail banks or brokerages. Because investors’ privacy is protected, disclosing their personal-access information for each non-managed account is unnecessary.

Financial planners use aggregate account software for analyzing a client’s total assets, liabilities, and net worth; income and expenses; and trends in assets, liability, net worth, and transaction values. The advisor also assesses various risks in a client’s portfolio before making investment decisions.

Effects of Account Aggregation

Many aggregation services offer direct data connections between brokerage firms and financial institutions, rather than using banks’ consumer-facing websites. Clients give financial institutions their consent by providing personal information for the aggregate services.

What Is Alpha?

Alpha (α) is a term used in investing to describe an investment strategy’s ability to beat the market, or its “edge.” Alpha is thus also often referred to as “excess return” or “abnormal rate of return,” which refers to the idea that markets are efficient, and so there is no way to systematically earn returns that exceed the broad market as a whole. Alpha is often used in conjunction with beta (the Greek letter β), which measures the broad market’s overall volatility or risk, known as systematic market risk.

Alpha is used in finance as a measure of performance, indicating when a strategy, trader, or portfolio manager has managed to beat the market return over some period. Alpha, often considered the active return on an investment, gauges the performance of an investment against a market index or benchmark that is considered to represent the market’s movement as a whole.

The excess return of an investment relative to the return of a benchmark index is the investment’s alpha. Alpha may be positive or negative and is the result of active investing. Beta, on the other hand, can be earned through passive index investing.

Understanding Alpha

Alpha is one of five popular technical investment risk ratios. The others are beta, standard deviation, R-squared, and the Sharpe ratio. These are all statistical measurements used in modern portfolio theory (MPT). All of these indicators are intended to help investors determine the risk-return profile of an investment.

Active portfolio managers seek to generate alpha in diversified portfolios, with diversification intended to eliminate unsystematic risk. Because alpha represents the performance of a portfolio relative to a benchmark, it is often considered to represent the value that a portfolio manager adds to or subtracts from a fund’s return.

In other words, alpha is the return on an investment that is not a result of a general movement in the greater market. As such, an alpha of zero would indicate that the portfolio or fund is tracking perfectly with the benchmark index and that the manager has not added or lost any additional value compared to the broad market.

The concept of alpha became more popular with the advent of smart beta index funds tied to indexes like the Standard & Poor’s 500 index and the Wilshire 5000 Total Market Index. These funds attempt to enhance the performance of a portfolio that tracks a targeted subset of the market.

Despite the considerable desirability of alpha in a portfolio, many index benchmarks manage to beat asset managers the vast majority of the time. Due in part to a growing lack of faith in traditional financial advising brought about by this trend, more and more investors are switching to low-cost, passive online advisors (often called roboadvisors​) who exclusively or almost exclusively invest clients’ capital into index-tracking funds, the rationale being that if they cannot beat the market they may as well join it.

Moreover, because most “traditional” financial advisors charge a fee, when one manages a portfolio and nets an alpha of zero, it actually represents a slight net loss for the investor. For example, suppose that Jim, a financial advisor, charges 1% of a portfolio’s value for his services and that during a 12-month period Jim managed to produce an alpha of 0.75 for the portfolio of one of his clients, Frank. While Jim has indeed helped the performance of Frank’s portfolio, the fee that Jim charges is in excess of the alpha he has generated, so Frank’s portfolio has experienced a net loss. For investors, the example highlights the importance of considering fees in conjunction with performance returns and alpha.

The Efficient Market Hypothesis (EMH) postulates that market prices incorporate all available information at all times, and so securities are always properly priced (the market is efficient.) Therefore, according to the EMH, there is no way to systematically identify and take advantage of mispricings in the market because they do not exist.

If mispricings are identified, they are quickly arbitraged away and so persistent patterns of market anomalies that can be taken advantage of tend to be few and far between.

Empirical evidence comparing historical returns of active mutual funds relative to their passive benchmarks indicates that fewer than 10% of all active funds are able to earn a positive alpha over a 10-plus year time period, and this percentage falls once taxes and fees are taken into consideration. In other words, alpha is hard to come by, especially after taxes and fees.

Because beta risk can be isolated by diversifying and hedging various risks (which comes with various transaction costs), some have proposed that alpha does not really exist, but that it simply represents the compensation for taking some un-hedged risk that hadn’t been identified or was overlooked.

Seeking Investment Alpha

Alpha is commonly used to rank active mutual funds as well as all other types of investments. It is often represented as a single number (like +3.0 or -5.0), and this typically refers to a percentage measuring how the portfolio or fund performed compared to the referenced benchmark index (i.e., 3% better or 5% worse).

Deeper analysis of alpha may also include “Jensen’s alpha.” Jensen’s alpha takes into consideration the capital asset pricing model (CAPM) market theory and includes a risk-adjusted component in its calculation. Beta (or the beta coefficient) is used in the CAPM, which calculates the expected return of an asset based on its own particular beta and the expected market returns. Alpha and beta are used together by investment managers to calculate, compare, and analyze returns.

The entire investing universe offers a broad range of securities, investment products, and advisory options for investors to consider. Different market cycles also have an influence on the alpha of investments across different asset classes. This is why risk-return metrics are important to consider in conjunction with alpha.

Examples

This is illustrated in the following two historical examples for a fixed income ETF and an equity ETF:

The iShares Convertible Bond ETF (ICVT) is a fixed income investment with low risk. It tracks a customized index called the Bloomberg U.S. Convertible Cash Pay Bond > $250MM Index. The 3-year standard deviation was 18.94%, as of Feb. 28, 2022. The year-to-date return, as of Feb. 28, 2022, was -6.67%. The Bloomberg U.S. Convertible Cash Pay Bond > $250MM Index had a return of -13.17% over the same period. Therefore, the alpha for ICVT was -0 12% in comparison to the Bloomberg U.S. Aggregate Index and a 3-year standard deviation of 18.97%.

However, since the aggregate bond index is not the proper benchmark for ICVT (it should be the Bloomberg Convertible index), this alpha may not be as large as initially thought; and in fact, may be misattributed since convertible bonds have far riskier profiles than plain vanilla bonds.

The WisdomTree U.S. Quality Dividend Growth Fund (DGRW) is an equity investment with higher market risk that seeks to invest in dividend growth equities. Its holdings track a customized index called the WisdomTree U.S. Quality Dividend Growth Index. It had a three-year annualized standard deviation of 10.58%, higher than ICVT.

As of Feb. 28, 2022, DGRW annualized return was 18.1%, which was also higher than the S&P 500 at 16.4%, so it had an alpha of 1.7% in comparison to the S&P 500. But again, the S&P 500 may not be the correct benchmark for this ETF, since dividend-paying growth stocks are a very particular subset of the overall stock market, and may not even be inclusive of the 500 most valuable stocks in America.

Alpha Considerations

While alpha has been called the “holy grail” of investing, and as such, receives a lot of attention from investors and advisors alike, there are a couple of important considerations that one should take into account when using alpha.

1. A basic calculation of alpha subtracts the total return of an investment from a comparable benchmark in its asset category. This alpha calculation is primarily only used against a comparable asset category benchmark, as noted in the examples above. Therefore, it does not measure the outperformance of an equity ETF versus a fixed income benchmark. This alpha is also best used when comparing the performance of similar asset investments. Thus, the alpha of the equity ETF, DGRW, is not relatively comparable to the alpha of the fixed income ETF, ICVT.
2. Some references to alpha may refer to a more advanced technique. Jensen’s alpha takes into consideration CAPM theory and risk-adjusted measures by utilizing the risk-free rate and beta.

When using a generated alpha calculation it is important to understand the calculations involved. Alpha can be calculated using various different index benchmarks within an asset class. In some cases, there might not be a suitable pre-existing index, in which case advisors may use algorithms and other models to simulate an index for comparative alpha calculation purposes.

Alpha can also refer to the abnormal rate of return on a security or portfolio in excess of what would be predicted by an equilibrium model like CAPM. In this instance, a CAPM model might aim to estimate returns for investors at various points along an efficient frontier. The CAPM analysis might estimate that a portfolio should earn 10% based on the portfolio’s risk profile. If the portfolio actually earns 15%, the portfolio’s alpha would be 5.0, or +5% over what was predicted in the CAPM model.