What Is Alpha?

Alpha (α) is a term used in investing to describe an investment strategy’s ability to beat the market, or its “edge.” Alpha is thus also often referred to as 澳洲幸运5官方开奖结果体彩网:excess return or the 澳洲幸运5官方开奖结果体彩网:abnormal rate of return✃ in relation to a benchmark, when adjusted for ri🔯sk.

Alpha is often used in conjunction with beta (the Greek letter β), which measures the broad market’s overall 澳洲幸运5官方开奖结果体彩网:volatility or risk, known as 澳洲幸运5官方开奖结果体彩网:systematic market risk.

Alpha is used in finance as a measure of 澳洲幸运5官方开奖结果体彩网:performance, indicating when a strategy, trader, or portfolio manager has managed to beat the market return or other benchmark over some period. Alpha, often considered the 澳洲幸运5官方开奖结果体彩网: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 𓂃movement 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 澳洲幸运5官方开奖结果体彩网:index investing.

Understanding Alpha

Alpha is one of five popular technical investment 澳洲幸运5官方开奖结果体彩网:risk ratios. The others are beta, 澳洲幸运5官方开奖结果体彩网:standard deviation, 澳洲幸运5官方开奖结果体彩网:R-squared, and the 澳洲幸运5官方开奖结果体彩网:Sharpe ratio. These are all statistical measurements used in 澳洲幸运5官方开奖结果体彩网:modern portfolio theory (MPT). All of these indicators are intended to help investors determine the risk-return profile of an inv♔estment.

Active portfolio managers seek to generate alpha in diversified portfolios, with 澳洲幸运5官方开奖结果体彩网:diversification intended to eliminate 澳洲幸运5官方开奖结果体彩网:unsystematic risk. Because alpha represents the performance of a 澳洲幸运5官方开奖结果体彩网:portfolio relative to a benchmark, it iꦬs often considered to represent the value that a ꦍportfolio 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 a 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 add🤪itional value compared to the broad market.

Applying Alpha to Investing

The concept of alpha became more popular with the advent of 澳洲幸运5官方开奖结果体彩网:smart beta index funds tied to indexes like the Standard & Poor’s 500 index and the Wilshire 5000 Tota🐈l Market Index. 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 澳洲幸运5官方开奖结果体彩网:robo-advisors​) who exclusively or almost exclusively invest clients’ capital into index-tracking funds, the rationale being that if they 澳洲幸运5官方开奖结果体彩网: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 澳洲幸运5官方开奖结果体彩网: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.

Efficient Market Hypothesis

The 澳洲幸运5官方开奖结果体彩网:efficient market hypothesis (EMH) postulates that market prices incorporate all available information at all times, so securities are always properl🐈y priced (the market is efficient). Therefore, according to the 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 澳洲幸运5官方开奖结果体彩网:arbitraged away, so p🗹ersistent patterns of market anomalies that can be taken ඣadvantage 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-plus-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 variou𝔍s risks (which comes with various transaction costs), some have proposed that alpha doe💛s not really exist, but simply represents the compensation for taking some unhedged risk that hadn’t been identified or was overlooked.

Seeking Investment Alpha

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 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).

A deeper analysis of alpha may also include 澳洲幸运5官方开奖结果体彩网:Jensen’s alpha. Jensen’s alpha takes into consideration the 澳洲幸运5官方开奖结果体彩网: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. 澳洲幸运5官方开奖结果体彩网:Alpha and beta are used together by investment managers to calculate, compar🌄e, and analyze returns.

The enti൲re 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.

Example of Alpha

Alpha is illustrated in the following two historical examples of a fixed-income 澳洲幸运5官方开奖结果体彩网:exchange-traded fund (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 U.S. Convertible Cash Pay Bond > $250MM Index. The three-year standard deviation was 18.94% as of Feb. 28, 2022. The year-to-date return, as of Feb. 28, 2022, was -6.67%. The Bloomberg U.S. Convertible Cash Pay Bond > $250MM Index had a return of -13.17% over the same period. Therefore, the alpha for ICVT was 6.5% compared to the Bloomberg U.S. Aggregate Index and a three-year standard deviation of 18.97%.

However, since the aggregate bond index is not the proper benchmark for ICVT (it should be the Bloomberg Convertible index), this alpha may not be as large as initially thought; in fact, it may be misattributed since 澳洲幸运5官方开奖结果体彩网:convertible bonds have far riskier profiles t♚han plain vanilla bonds.

The WisdomTree U.S. Quality 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 had a three-year annualized standard deviation of 10.58%, higher than ICVT.

As of Feb. 28, 2022, DGRW’s annualized return was 18.1%, which was also higher than the S&P 500 at 16.4%, so it had an alpha of 1.7% compared 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 the United States.

Alpha Considerations

While alpha has been called the “holy grail” of investing, and as such rec🐼eives 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 vs. a fixed-income benchmark. This alpha is also best used when comparing the 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 澳洲幸运5官方开奖结果体彩网: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 澳洲幸运5官方开奖结果体彩网:algorithms and other models to simulate an index foဣr 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 澳洲幸运5官方开奖结果体彩网:equilibrium model like CAPM. In this instance, a CAPM might aim to estimate returns for investors at various points along an 澳洲幸运5官方开奖结果体彩网:efficient frontier. The CAPM analysis might estimate that a portfolio should earn 10% based on the portfolio’s risk profile. If t♕he p💖ortfolio actually earns 15%, the portfolio’s alpha would be 5.0, or +5% over what was predicted in the CAPM.

The Bottom Line

The goal of an investor is to achieve the highest returns possible. Alpha is a measure of performance regarding investment returns that are better when compared to a benchmark when adjusted for risk. Activ🌠e investors seek to achieve returns that are high♋er than a benchmark and can employ a variety of strategies to do so. Many funds, such as hedge funds, have the purpose of achieving alpha and charge high management fees for doing so.