Alpha

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What is 'Alpha'

Alpha is used in finance as a measure of performance. Alpha, often considered the active return on an investment, gauges the performance of an investment against a market index or benchmark which 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 is used for mutual funds and all types of investments. 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 in conjunction with beta, which measures volatility or risk. Alpha is also often referred to as “excess return” or “abnormal rate of return.”

Deeper analysis of alpha may also include “Jensen’s alpha.” Jensen’s alpha takes into consideration capital asset pricing model (CAPM) market theory and includes a risk-adjusted component in its calculation.

BREAKING DOWN 'Alpha'

Alpha is one of five 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.

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 value.

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 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 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.

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 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 has a relatively low annual standard deviation of 4.72%. Year-to-date as of November 15 its return is 13.17%. Year-to-date the Bloomberg Barclays U.S. Aggregate Index has a return of 3.06%. Therefore the alpha for ICVT is 10.11% in comparison to the Bloomberg Barclays U.S. Aggregate Index and it offers relatively low risk with a standard deviation of 4.72%.

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.

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 preexisting 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, or 5% over what was predicted in the CAPM model.

Want to read more on alpha? Check out A Deeper Look at AlphaBettering Your Portfolio with Alpha and BetaAdding Alpha without Adding Risk, Jensen’s alpha and 5 Ways to Measure Mutual Fund Risk.