Is alpha the best risk measure?

There are many different types of risk associated with investing, and it is almost impossible for any single technical indicator to capture and effectively quantify them all. A risk measure that proves reliability in one area might be useless in another context. Alpha is one of the most commonly quoted performance tracking indicators, but that does not necessarily make it the best.

Alpha is one of the five major risk management indicators for mutual funds, stocks and bonds. Investors use it to track historical performance after adjusting for risk, and it is widely considered to be a reflection of a mutual fund manager's performance. This makes alpha especially useful for comparing mutual funds with longer track records.

Alpha compares the performance of a security or fund against a related benchmark index but modifies that performance by taking the asset's volatility into consideration. In a sense, alpha tells investors if the asset has performed better or worse than its beta predicts.

A mutual fund with an alpha of zero generates returns exactly in accordance with its volatility adjusted expectations. Values higher than zero mean the mutual fund performed better than expected, while negative values show underperformance. Consistently high alphas suggest the mutual fund manager consistently generated higher returns than might have been expected under market conditions.

Investors should also consider the underlying assumptions of any risk measure. Alpha is constructed and applied based on modern portfolio theory and uses a least squares regression to generate returns. Regardless of its efficacy within that framework, it is possible, though not necessarily true, that other conceptual methodologies might prove more useful.