Alpha

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DEFINITION of '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.

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