What Is an Alpha Generator?

An alpha generator is any security that, when added by an investor to an existing portfolio of assets, generates excess returns or returns higher than a pre-selected benchmark without additional risk. Banks, hedge funds, and quantitative traders will sometimes use algorithmic trading technology to help identify alpha generators that will allow them to outperform or beat the market over time.

An alpha generator can be any security, including government bonds, foreign stocks, or derivative products such as stock options and futures. New alpha generators can also occur from the expansion of investments into a new category.

Key Takeaways

  • An alpha generator is a type of security that when added to an existing portfolio can spark bigger returns than a pre-selected benchmark with no additional risk.
  • Any security can be used as an alpha generator, whether it's a stock, bond, international equity, or derivative product.
  • In theory, an investor can grow their portfolio returns by expanding their targeted investment universe to include alpha generators.
  • International and emerging market stocks are a popular way to add an alpha generator to a portfolio, as well as initial public offerings (IPOs) or funds that track IPOS.

How an Alpha Generator Works

Alpha generators can create substantially higher returns for investors. Alpha generators may be individual stocks, bonds, or derivative products. Often alpha generators occur from the expansion of an investor’s allowable universe. For example, adding international investments to broaden an investor’s portfolio can result in higher returns from both fixed income and equity investments.

Since alpha can be a measure of the returns a portfolio produces in excess of the return estimated by the capital asset pricing model, on a risk-adjusted basis, theoretically an investor can measurably add to portfolio returns when expanding their investment universe to include new types of alpha generators.

This can all be done through modern portfolio theory, which allows for targeted expansion of the investable universe and can result in an upward shift of the efficient frontier and capital market line when alpha generators are added. With new alpha generators influencing the capital market line, an investor’s portfolio can expect to see higher returns through allocations that now integrate new alpha-generating securities into the portfolio mix with minimal risk.

Alpha is one of five well-known technical investment indicators that investors can use to evaluate the risk-return profile of an investment. The other indicators are beta, R-squared, standard deviation, and the Sharpe ratio.

International Investments as an Alpha Generator

International investments are one way to add a targeted group of alpha generators to a portfolio. Emerging market investments, in particular, are one area that can broadly be considered alpha generators. Both emerging market debt and emerging market equity offer higher returns than average benchmarks globally with some additional risk.

An investor that expands their entire portfolio to include emerging market investments can ultimately shift their capital market line higher with the integration of emerging market debt in the more conservative portion of their allocations and emerging market equity in the higher risk portions of their portfolio.

Examples of Alpha Generators

Other areas of the market can substantially add alpha, specifically through more concentrated investments. An example of this is initial public offerings (IPOs), which can be a significant alpha generator. This group of the market offers high growth potential from companies that have established significant momentum. Investors can choose to invest in individual stocks, IPO funds, or index funds that track IPOs.

Other groups of the market often identified as alpha generators include FAANG stocks, BRIC countries, and Asia ex-Japan. Some investors may also find significant alpha generation from the use of derivatives.

ESG Investing

Environmental, social, and governance (ESG) investing refers to an increasingly popular trend that enables investors to put their money where their values are by investing in companies that adhere to specific criteria regarding environmental, governance, and social factors. ESG investing also helps steer investors away from companies that face increased risk due to their environmental or social practices. ESG investing is often referred to as socially responsible investing or sustainable investing.

A 2021 study of financial professionals, fund selectors, and institutional investors shows that sentiment is shifting toward viewing ESG investing as an alpha generator. Over 60% of those institutions surveyed said there was alpha potential to be found in ESG, while 70% of fund selectors saw alpha potential in ESG. The survey revealed investor demand is fueling the growth of ESG investing, combined with growing social awareness, concerns about climate change, and a desire to be part of the green economy.