What is an Alpha Generator
An alpha generator is any security that, when added to an existing portfolio of assets, generates excess returns or returns higher than a pre-selected benchmark without additional risk. 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.
BREAKING DOWN Alpha Generator
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.
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.
Other Alternative Investments
Other areas of the market can substantially add alpha, specifically through more concentrated investments. Initial public offerings (IPO) 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.