Loading the player...

What is 'Alpha'

Alpha is used in finance to represent two things:

1. A measure of performance on a risk-adjusted basis.

Alpha, often considered the active return on an investment, gauges the performance of an investment against a market index used as a benchmark, since they are often considered to represent the market’s movement as a whole. The excess returns of a fund relative to the return of a benchmark index is the fund's alpha.

Alpha is most often used for mutual funds and other similar investment types. It is often represented as a single number (like 3 or -5), but this refers to a percentage measuring how the portfolio or fund performed compared to the benchmark index (i.e. 3% better or 5% worse).

Alpha is often used with beta, which measures volatility or risk, and is also often referred to as “excess return” or “abnormal rate of return.”

2. The abnormal rate of return on a security or portfolio in excess of what would be predicted by an equilibrium model like the capital asset pricing model (CAPM).

In this context, alpha is often known as the “Jensen index.”

BREAKING DOWN 'Alpha'

1. Alpha is one of five technical 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 a mutual fund.

Using alpha in measuring performance assumes that the portfolio is sufficiently diversified so as 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 general movement in the greater market. As such, an alpha of 0 would indicate that the portfolio or fund is tracking perfectly with the benchmark index and that the manager has not added or lost any value.

The concept of alpha was born with the advent of weighted index funds like the S&P 500 for the stock market and the Wilshire 5000 for the securities market, which attempt to emulate the performance of a portfolio that encompasses the entire market and that gives each area of investment proportional weight. With this development, investors could hold their portfolio managers to a higher standard of just producing returns: producing returns greater than the investor would have made with a blanket market-wide portfolio.

Yet, despite the considerable desirability of alpha in a portfolio, 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 robo-advisors​) who exclusively or almost exclusively invest clients’ capital into index-tracking funds, the thought 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 0, 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 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. Because of these developments, managers face more pressure than ever to produce results.

Evidence shows that active managers’ rates of achieving alpha in funds and portfolios have been shrinking substantially, with about 20% of managers producing statistically significant alpha in 1995 and only 2% in 2015. Experts attribute this trend to many causes, including:

  • The growing expertise of financial advisors
  • Advancements in financial technology and software that advisors have at their disposal
  • Increasing opportunity for would-be investors to engage in the market due to the growth of the internet
  • A shrinking proportion of investors taking on risk in their portfolios and
  • The growing amount of money being invested in pursuit of alpha

2. CAPM analysis aims to estimate returns on a portfolio or fund based on risk and other factors. For example, a CAPM analysis may estimate that a portfolio should earn 10% based on the portfolio’s risk profile. Yet, supposing that the portfolio actually earns 15%, the portfolio's alpha would be 5, or 5% over what was predicted in the CAPM model.

This form of analysis is often used in non-traditional funds, which are less easily represented by a single index.

Limitations of 'Alpha'

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 before attempting to use alpha.

One such consideration is that alpha is used in the analysis of a wide variety of fund and portfolio types. Because the same term can apply to investments of such differing natures, there is a tendency for people to attempt to use alpha values to compare different kinds funds or portfolios with one another. Because of the intricacies of large funds and portfolios, as well as of these forms of investing in general, comparing alpha values is only useful when the investments contain assets in the same asset class.

Additionally, because alpha is calculated relative to a benchmark deemed appropriate for the fund or portfolio, when calculating alpha it is imperative that an appropriate benchmark is chosen. Because funds and portfolios vary, it is possible that there is no suitable preexisting index, in which case advisors will often use algorithms and other models to simulate an index for comparative purposes.

Want to read more on Alpha? Check out A Deeper Look At AlphaBettering Your Portfolio With Alpha And BetaAdding Alpha Without Adding Risk and 5 Ways To Measure Mutual Fund Risk.

RELATED TERMS
  1. Portable Alpha

    A strategy in which portfolio managers separate alpha from beta ...
  2. Alpha Generator

    Any security that, when added to an existing portfolio of assets, ...
  3. Jensen's Measure

    A risk-adjusted performance measure that represents the average ...
  4. Tainted Alpha

    An alpha return that cannot be attributed solely to the money ...
  5. Excess Returns

    Investment returns from a security or portfolio that exceed a ...
  6. Appraisal Ratio

    A ratio used to measure the quality of a fund's investment picking ...
Related Articles
  1. Investing

    Alpha and Beta for Beginners

    An in-depth look at what alpha and beta are and what they measure.
  2. Trading

    Bettering Your Portfolio With Alpha And Beta

    Increase your returns by creating the right balance of both these risk measures.
  3. Investing

    Evaluating Alpha and Beta

    Alpha and beta are risk ratios that investors use to calculate, compare and predict returns.
  4. Financial Advisor

    A Deeper Look At Alpha

    The Jensen index helps investors compare realized returns to what should've been achieved.
  5. Investing

    Pursuing Alpha In A Well-Diversified IRA

    This strategy is not as complex as some investment gurus would like you to believe.
  6. Financial Advisor

    Measuring And Managing Investment Risk

    Risk is inseparable from return. Learn more about these measures and how to balance them.
  7. Investing

    5 Ways To Measure Mutual Fund Risk

    These statistical measurements highlight how to mitigate risk and increase rewards.
  8. Investing

    How Investment Risk Is Quantified

    FInancial advisors and wealth management firms use a variety of tools based in Modern portfolio theory to quantify investment risk.
  9. Investing

    Adding Alpha Without Adding Risk

    Learn how to generate higher returns in your portfolio while keeping the same risk profile.
  10. Investing

    Understanding Volatility Measurements

    How do you choose a fund with an optimal risk-reward combination? We teach you about standard deviation, beta and more!
RELATED FAQS
  1. What is the Weighted Alpha formula and how is it calculated?

    Find out how investors and analysts calculate the weighted alpha of a stock's price by emphasizing recent price movements ... Read Answer >>
  2. Is alpha the best risk measure?

    Read about some of the strengths and weaknesses of alpha, a popular risk-adjusted performance indicator based on modern portfolio ... Read Answer >>
  3. Does a negative alpha automatically mean I should sell?

    Learn how alpha is used to assess an investment's profitability relative to the broader market and why a negative value isn't ... Read Answer >>
  4. What are the best technical indicators to complement Weighted Alpha?

    Find out how technical analysts and traders use a stock's weighted alpha to confirm momentum or select specific stocks to ... Read Answer >>
  5. How do I use Weighted Alpha to create a forex trading strategy?

    Find out how the concept of weighted alpha can be applied to currency contracts in the foreign exchange market to spot potentially ... Read Answer >>
  6. What's the difference between alpha and beta?

    Learn about alpha and beta, two very important technical risk ratios that investors use to evaluate relative performance, ... Read Answer >>
Hot Definitions
  1. IRS Publication 970

    A document published by the Internal Revenue Service (IRS) that provides information on tax benefits available to students ...
  2. Federal Direct Loan Program

    A program that provides low-interest loans to postsecondary students and their parents. The William D. Ford Federal Direct ...
  3. Cash Flow

    The net amount of cash and cash-equivalents moving into and out of a business. Positive cash flow indicates that a company's ...
  4. PLUS Loan

    A low-cost student loan offered to parents of students currently enrolled in post-secondary education. With a PLUS Loan, ...
  5. Graduate Record Examination - GRE

    A standardized exam used to measure one's aptitude for abstract thinking in the areas of analytical writing, mathematics ...
  6. Graduate Management Admission Test - GMAT

    A standardized test intended to measure a test taker's aptitude in mathematics and the English language. The GMAT is most ...
Trading Center