Updated: 4 days ago

Alpha, the "holy grail" of investing. Alpha is often used to quantify an investment strategy's ability to outperform the market. It can be thought of as the portion of a strategy's return that is attributable to a manager's skill.

For example, if a strategy has an alpha equal to 0, then that strategy is said to have earned a return inline with the risk that was taken.

If alpha is positive, then that strategy has earned a return greater than what would be expected given its risk level. In this case, the skill level of the manager has contributed to that strategy's outperformance. Some actions a manager can take to generate positive alpha include market timing, tactical portfolio construction, and hedging.

On the other hand, if alpha is negative, then that strategy has earned a return lower than what would be expected given its risk level. Here, actions taken by the manager have actually degraded performance. In this instance, an investor would have been better off investing in a passive fund.

Alpha Formula

Alpha is derived from the Capital Asset Pricing Model (CAPM). We can apply CAPM to an entire portfolio to derive its expected return. We then subtract that from the portfolio's realized return to determine the difference, which we define as alpha.

In the above formula, the S&P 500 is often used as the benchmark because it is a good proxy for the market.

Understanding Alpha

Now that you know what alpha is, how can we use it to evaluate a strategy's performance? Let's look at a few examples.

Say a fund returned 20% in a year when the market returned 10%. At first glance, it might seem that this is a very good fund. It outperformed the market by 2x. However, upon closer examination, say we discover this fund had an alpha close to 0%. This means the strategy performed inline with expectations given its risk level. We might dive deeper and discover that the fund closely mimicked a growth index. When compared to the overall market, growth stocks have more risk, but also more potential reward. In this case, the fund did not beat the market primarily through skill, but rather through exposure to riskier assets. An investor would have been better off buying the growth index instead of investing in the fund.

No say a fund returned 5% in a year when the market returned 10%. We might initially think this fund underperformed the market. But, of course, we now know there's more than meets the eye. Let's say alpha was 5%. This means that nearly all of the fund's returns were attributable to the manager's skill and were not due to market movements. In this case, sophisticated investors will often pay a premium for this fund even though overall returns were "low." This kind of alpha is typically seen in hedge funds that use long/short and/or market neutral strategies. The goal of these strategies is to deliver consistent returns in all market environments (e.g. make 5% a year regardless of if the market was up or down).

So What?

You now know that absolute performance isn't everything. A fund can outperform the market by simply holding more risk, but that doesn't necessarily make it a good investment. Therefore, when evaluating a fund's performance, it's important to take into account alpha. Alpha reveals how a fund performed relative to expectations given its level of risk. It also reveals how much of a fund's performance is attributable to the manager's skill.

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