Loading the player...

What is 'Alpha'

"Alpha" (the Greek letter α) is a term used in investing to describe a strategy's ability to beat the market, or it's "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.

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.

BREAKING DOWN 'Alpha'

Alpha is one of five popular technical risk ratios. The others are betastandard deviationR-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 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 S&P 500 and the Wilshire 5000. 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 robo-advisors​) 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 markets 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 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+ 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

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.

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 Barclays U.S. Convertible Cash Pay Bond > $250MM Index.

ICVT had a relatively low annual standard deviation of 4.72%. Year-to-date, as of November 15, 2017, its return was 13.17%. The Bloomberg Barclays U.S. Aggregate Index had a return of 3.06% over the same period. Therefore the alpha for ICVT was 10.11% in comparison to the Bloomberg Barclays U.S. Aggregate Index and for a relatively low risk with a standard deviation of 4.72%. However, since the aggregate bond index is not the proper benchmark for ICVT (it should be the Bloomberg Barclay's Convertible index), this alpha may not be as large as initially thought, and in fact may be mis-attributed since convertible bonds have far riskier profiles than plain vanilla bonds.

The Wisdom Tree U.S. 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 has a three year annualized standard deviation of 10.58%, higher than ICVT. Its year-to-date return as of November 15, 2017 is 18.24% which is higher than the S&P 500 at 14.67%, so it has an alpha of 3.57% 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.

The above example illustrates the success of two fund managers in generating alpha. Evidence, however, shows that active managers’ rates of achieving alpha in funds and portfolios across the investment universe are not always this successful. Statistics show that over the past ten years, 83% of active funds in the U.S. fail to match their chosen benchmarks. 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

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 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.

(Want to read more about alpha? Check out: A Deeper Look at AlphaBettering Your Portfolio with Alpha and Beta; Adding Alpha without Adding Risk; Jensen’s alpha; and 5 Ways to Measure Mutual Fund Risk.)

RELATED TERMS
  1. Portable Alpha

    Portable alpha is a strategy in which portfolio managers separate ...
  2. Excess Returns

    Excess returns, also known as alpha, measure the percentage that ...
  3. Alpha Risk

    Alpha risk is the risk in a statistical test of rejecting a null ...
  4. Risk Measures

    Risk measures give investors an idea of the volatility of a fund ...
  5. Market-Maker Spread

    The market-maker spread is the difference between the prices ...
  6. Relative Return

    Relative return is the return an asset achieves over a period ...
Related Articles
  1. Investing

    Alpha and beta for beginners

    Alpha and beta are both risk ratios that investors use as a tool to calculate, compare and predict returns. Here is 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

    5 ways to measure mutual fund risk

    Statistical measures such as alpha and beta can help investors understand investment risk on mutual funds and how it relates to returns.
  4. 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.
  5. Investing

    Adding Alpha Without Adding Risk

    Learn how to generate higher returns in your portfolio while keeping the same risk profile.
  6. Financial Advisor

    Measure Your Portfolio's Performance

    Measuring the success of your investment solely on the portfolio return may leave you blindsided to risk. Learn how to evaluate your investment return.
  7. Investing

    Vanguard 500 Index Fund Investor Risk Statistics

    A risk statistics case study of the Vanguard 500 Index Fund sheds light on its historical beta, alpha, Treynor ratio and volatility.
  8. Investing

    Top 3 Alliance Bernstein Fixed-Income Mutual Funds (ANAGX, ABQIX)

    Explore three AllianceBernstein fixed-income mutual funds with strong risk-adjusted returns, low expense ratios and high ratings from Morningstar.
  9. Investing

    Understanding Volatility Measurements

    Learn how to choose a fund with an optimal risk-reward combination. Find more information about standard deviation, beta, and more.
RELATED FAQS
  1. Is negative alpha a signal to sell an investment?

    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 >>
  2. What's the difference between alpha and beta?

    Alpha is a measurement of a portfolio manager's performance in relation to the overall market. Beta gauges the volatility ... Read Answer >>
  3. What's the relationship between R-squared and beta?

    Learn about the relationship between R-squared and beta. Explore how the concepts are related and often used in conjunction ... Read Answer >>
  4. How do I interpret a Security Market Line (SML) graph?

    Find out how to interpret stocks and portfolios through a security market line, or SML, graph as part of the Capital Asset ... Read Answer >>
Trading Center