Loading the player...

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.

[ Traders use a variety of different strategies to generate alpha in their portfolios, ranging from value investing to statistical arbitrage. If you're interested in improving your alpha, Investopedia's Trading for Beginners Course will teach you everything you need to know to get started. You'll learn the fundamental of trading while being guided through the process of building a complete trading system that matches your risk tolerance in over 50 lessons consisting of on-demand video, exercises, and interactive content. Check it out! ]

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.

RELATED TERMS
  1. Alpha Generator

    An alpha generator is any security that, when added to an existing ...
  2. Jensen's Measure

    Jensen's measure, or "Jensen's alpha," indicates the portion ...
  3. Tainted Alpha

    Tainted alpha refers to the portion of alpha return that cannot ...
  4. Risk Management

    Risk management occurs anytime an investor or fund manager analyzes ...
  5. Alpha Risk

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

    Risk measures give investors an idea of the volatility of a fund ...
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. Financial Advisor

    A Deeper Look At Alpha

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

    Pursuing Alpha In A Well-Diversified IRA

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

    Who's The Better Financial New Source: The Motley Fool or Seeking Alpha

    This is a comparison of two of the most popular investment research sites: The Motley Fool and Seeking Alpha.
  6. Financial Advisor

    Does Your Investment Manager Measure Up?

    These key stats will reveal whether your advisor is a league leader or a benchwarmer.
  7. 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.
  8. Investing

    Find Out All About Vanguard 500 Index Fund!

    Discover a risk statistics case study of the Vanguard 500 Index Fund, and learn about its historical beta, alpha, Treynor ratio and volatility.
  9. Investing

    Understanding Volatility Measurements

    How do you choose a fund with an optimal risk-reward combination? Here we teach you about standard deviation, beta and more.
  10. Investing

    T Rowe Price Capital Appreciation Fund Risk Statistics Case Study (PRWCX)

    Analyze PRWCX using popular risk metrics that are part of modern portfolio theory (MPT). Explore PRWCX's volatility, correlation and return statistics.
RELATED FAQS
  1. 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 >>
  2. How does beta measure a stock's market risk?

    Learn how beta is used to measure risk versus the stock market, and understand how it is calculated and used in the capital ... Read Answer >>
Hot Definitions
  1. Futures Contract

    An agreement to buy or sell the underlying commodity or asset at a specific price at a future date.
  2. Yield Curve

    A yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but ...
  3. Portfolio

    A portfolio is a grouping of financial assets such as stocks, bonds and cash equivalents, also their mutual, exchange-traded ...
  4. Gross Profit

    Gross profit is the profit a company makes after deducting the costs of making and selling its products, or the costs of ...
  5. Diversification

    Diversification is the strategy of investing in a variety of securities in order to lower the risk involved with putting ...
  6. Intrinsic Value

    Intrinsic value is the perceived or calculated value of a company, including tangible and intangible factors, and may differ ...
Trading Center