What Is Alpha?
Paradoxically, alpha (α) in investing represents an investment strategy’s ability to beat the market – its ‘edge’. Alpha is therefore also referred to as excess return or the abnormal rate of return over and above the benchmark once the risk of the investment relative to its benchmark has been accounted for.
Alpha is usually paired with beta (the Greek letter β), a measure of the total volatility (or risk) of the broad market, or systematic market risk.
In finance, alpha refers to performance – when a strategy, trader or portfolio manager outperforms the market return or some other benchmark during a certain period. Alpha, sometimes referred to as the active return in an investment, measures how an investment performed relative to a market index or benchmark that is thought to approximate the ‘movement’ of the market.
This excess return, relative to return of an appropriate benchmark index, is the active component of an investment. This component is referred to as alpha. Alpha can be positive or negative. It is the payoff to active investing. Beta, on the other hand, can be earned by passive passive index investing.
Key Takeaways
Alpha is the additional return you earn on an investment relative to the benchmark return, after accounting for risk.
Diversification is the tool that active portfolio managers use to attempt to create alpha in diversified portfolios. Since a portfolio of securities chosen, say, on the basis of similarity to Warren Buffett’s approach is fully diversified, it is protecting against only the market risk inherent in any portfolio with significant holdings, and not expected to create any meaningful outperformance.
Given that alpha is a measure of the excess return from a portfolio over a benchmark, it’s usually seen as signifying how much value a portfolio manager adds – or indeed detracts – from the return to a fund.
Jensen’s alpha modifies the calculation by taking into account the CAPM, incorporating a risk-adjusted element.
Understanding Alpha
Alpha is one of five prominent technical investment risk ratios—the others are beta, standard deviation, R-squared, and the Sharpe ratio. All are statistical measurements used in modern portfolio theory (MPT). The purpose of all these indicators is to help investors calculate the risk-return profile of the investment.
Active portfolio managers aim to create alpha from a diversified portfolio, where the diversification is presumably designed to neutralise unsystematic risk. As alpha represents the performance of one portfolio relative to another benchmark, it is generally thought to capture the value-added, or value-detracted, by a portfolio manager from the return of a fund.
In other words, alpha is the gain made on an investment that is not a result of a general movement in the aggregate or wider market. As such, an alpha of zero would mean the portfolio or fund is tracking perfectly with the benchmark index, and the manager is adding or subtracting no more value than the wider market.
Applying Alpha to Investing
Alpha got wrapped into current portfolio management zeitgeist from smart beta index funds that are benchmarked against an index such as the US-focused Standard S Poor’s 500 index or a more broadscale US equity index such as the Wilshire 5000 Total Market Index, which provides access to the entire investable US equity market and aims to produce excess returns relative to a market-capitalisation index.
Notwithstanding such great alpha potentiality in a portfolio, the fact is that the vast majority of the time asset managers end up trailing index benchmarks. Combined with growing consumer skepticism in the traditional investment advice model, the result is that more and more people are ditching investment advisors for low-cost passive online advisors (what the tech world calls ‘robo-advisors’) that invest clients’ capital largely or completely into index trackers. After all, if they can’t beat it, join it.
And, also, because most traditional financial advisors charge a fee, when one ‘beats the market’ and earns an alpha of zero, what you’ve actually accomplished is a bit of a net loss for the investor. Take John, for instance, a financial advisor who charges 1 per cent of the value of a portfolio for his services, and who over any given 12-month timeframe managed for his client Frank to earn an alpha of 0.75.
While Jim has indeed increased the performance of Frank’s portfolio, the fee earned by Jim is greater than the alpha-generating progress he has produced, so the portfolio in which he has been engaged actually shows a net loss. For investors, the example emphasises the need to think in terms of, and to compare, either all three components of performance (net return, alpha and fee) or only two of them (either net return and fee or net return and alpha) but not just one of them.
Efficient Market Hypothesis
The efficient market hypothesis (EMH) says that all information is embedded in the observed market price at all times, and that therefore securities are properly priced (the market is efficient) and that there is no way to systematically identify and capitalise on mispricings because they effectively do not exist.
And if mispricings occur, they quickly get eliminated by arbitragers, so pervasive patterns of market anomalies that can be exploited are likely to be scarce
empirical record contrasting historic returns for active mutual funds with their passive benchmarks clearly reveals that fewer than 10 per cent of active funds earn a positive alpha over a 10-plus-year horizon, and that number declines rapidly once deductions for taxes and fees are considered. Alpha is difficult to find, and even more difficult to keep once the government and the investment firm get hold of it.
Since it can be isolated by diversifying and hedging other risks (with various transaction costs incurred in the process), some have argued that alpha doesn’t exist as such, but instead simply compensates in a specific way for taking some other unidentified (or overlooked) unhedged risk.
Seeking Investment Alpha
Alpha is also used to rank active mutual funds (and indeed, just about every other type of investment), with a single (absolute) number (eg, +3.0 or –5.0), often expressed as a percentage difference in results between a portfolio or fund and its chosen benchmark index, eg, 3 per cent better or 5 per cent worse.
A more nuanced look at alpha would consider Jensen’s alpha, which accounts for CAPM (capital asset pricing model) market theory by incorporating an element of risk-adjustment. Beta (or the beta coefficient) in the CAPM equation predicts the probable return on an asset based on its own ‘beta’ (or sensitivity to movements in the market) and on the expected market returns. Alpha and beta are run by investment managers to calculate, compare and weigh returns.
As a result, the entire investment universe offers a vast array of securities, investment products and ways to use advice. Different market cycles likewise impact the level of alpha in various asset classes. The reason that risk-return metrics are helpful to consider alongside alpha, therefore, is that they tell us that there is a trade-off between risk and return to consider.
Example of Alpha
Alpha can be seen in the two historical examples of a fixed-income ETF and an equities ETF, below:
Figure 4. Shows the three-year standard deviation for the ICVT is 18.94% and these four-year ratio is 1.52 as published in Bloomberg (as of 28 Feb 2022). The year-to date return of ETF is -6.67% as published in Bloomberg (28 Feb 2022). The Bloomberg U.S. Convertible Cash Pay Bond > $250MM Index had a return of -13.17% over the same period. The alpha for ETF was 6.5% vs the Bloomberg U.S. Aggregate Index and three-year standard deviation 18.97%.
But since the aggregate bond index is the wrong benchmark for ICVT (it should be Bloomberg Convertible, instead), this alpha is unlikely to be as large as tail-weighted portfolios would describe; it could even be the wrong alpha, since convertible bonds are much more risky than plain vanilla bonds.
The WisdomTree U S Quality Dividend Growth Fund (DGRW) is also an equity, but with more market risk than ICVT too. Yet, it seeks to track dividend growth equities by investing in the shares that correspond to the holdings of a customised index called the WisdomTree U S Quality Dividend Growth Index. Its three-year annualised standard deviation was 10.58 per cent (higher than ICVT).
As of Feb. 28, 2022, DGRW’s annualised return was 18.1 per cent, and it got there with an alpha of 1.7 per cent versus the S&P 500, again so it beat the S&P 500 but maybe not by much. Trouble is, the S&P 500 likely isn’t the right benchmark for such an ETF, as dividend-paying growth stocks are a very specific subset of the stock market and perhaps not even the 500 most valuable stocks in the US in the first place.
Alpha Considerations
Although he calls alpha the ‘holy grail’, erroneous calculations typically occur when investors or advisers apply alpha. There are two considerations when using alpha.
Roughly put, the simple alpha calculation +/- is the total return of an investment minus the total return of a benchmark from the asset category to which it belongs. Since alphas are solely calculated against an asset category benchmark, as documented in the examples above, it makes no sense to compare the outperformance of, for example, an equity ETF against a comparable fixed-income benchmark. And because alphas work best when paired against similar investments, the alpha of the equity ETF, DGRW, is not relatively analogous to the alpha of its counterpart, the fixed-income ETF, ICVT.
Some references to alpha might relate to a more advanced technique. Jensen’s alpha is sensitive to CAPM theory and risk-adjusted measures using risk-free rate and beta.
Bear in mind a warning: with an outsourced generated alpha calculation, you may have limited knowledge of the calculations performed. Arguably, if one chooses to benchmark an asset with a traditional asset class approach, one should use one appropriate preexisting index for an asset class.
There could be different ways to construct an index for an asset class, but if there doesn’t exist a benchmark that seems suitable, one might choose to outsource index construction (where the alpha-provider might have proprietary index constructions for specific asset classes). However, in some cases, we may be unable to benchmark managers with a preexisting index for an asset class. In that case, advisors have employed their own algorithms and other models to simulate an index for the manager, which they can then use to compare its ‘alpha’.
However, alpha can also refer to an abnormal rate of return for a security or market portfolio: that is, a return in excess of that which is predicted by an equilibrium model such as the CAPM. In such a case, a CAPM might attempt to predict a return to the investor for a portfolio at one point or another along the efficient frontier. For example, suppose that the CAPM predicted that a portfolio should earn 10 per cent given the risk profile of that particular portfolio. If the portfolio actually earns 15 per cent, the alpha of that portfolio would be 5.0, or +5 per cent over that which was predicted in the CAPM.
What Are Alpha and Beta in Finance?
Alpha is defined as the return you get over and above the benchmark you are comparing to; beta is the volatility, or risk, measure of your strategy. Alpha returns are what active investors are aiming for.
What Is a Good Alpha in Finance?
In financial markets trading and investing, the meaning of a ‘good’ alpha depends a lot on the trading objective and the risk appetite. Generally though, we might say a good alpha is whatever is larger than zero (after risk adjustment) for any given risk-return trade-off.
What Does a Negative Alpha Mean in Stocks?
So a negative alpha in stocks means that a stock is doing more poorly than the benchmark optionally inflated for risk. If an investor wishes to either match or beat a certain benchmark and is doing worse than that benchmark in his portfolio, then he has negative alpha.
The Bottom Line
The aim of an investor is to earn as much as possible in returns. Alpha is relative to the aim of attaining better returns, when adjusted for the amount of risk, which is delivered when compared with a benchmark. Active investors strive to get higher returns than a benchmark. There are a number of ways that an active investor can attempt to achieve a return above the benchmark. Many types of funds, such as mutual funds known as hedge funds, are set up to achieve alpha and charge high management fees for doing so.
