Alpha: The Holy Grail of Investing
Updated: Sep 22, 2022
Alpha, also known as the "holy grail" of investing, is a term used to describe an investment strategy’s ability to beat the market (after adjusting for market-related volatility). Alpha can also be thought of as a proxy for a portfolio manager’s skill or value-add. Higher alpha values are better than lower ones.
For example, if a strategy has an alpha of 0, then that strategy is said to have earned a return in line with the risk that was taken. In this case, the manager neither added nor subtracted value.
If alpha is positive, say 1%, then that strategy outperformed the market by 1%. In other words, the strategy earned a return greater than what would be expected given its risk level. In this case, the portfolio manager's contributed positively to the strategy. 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, say -1%, then that strategy underperformed the market by 1%. That is to say, the strategy has earned a return lower than what would be expected given its risk level. In this instance, the strategy would have actually performed better without the actions taken by the manager.
Alpha is derived from the Capital Asset Pricing Model (CAPM). Apply CAPM to an entire portfolio to derive its expected return. Then subtract that from the portfolio's realized return to determine the difference. That difference is the alpha value.
In the above formula, the S&P 500 is often used as the benchmark because it is a good proxy for the market.
Now that you know what alpha is, how can you use it to evaluate a strategy's performance? In general, higher alpha values are better. If two strategies have similar returns, choose the one with the higher alpha. 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 because it outperformed the market by 2x. However, upon closer examination, say you discover this fund had an alpha close to 0%. This means the strategy actually performed in line with expectations given its risk level. Say that upon further research, you discover that the fund's holdings closely mimicked a growth index. When compared to the overall market, growth stocks have more risk, but also more potential reward. So in this case, the fund did not beat the market through skill, but rather through exposure to riskier assets. Here, you would have been better off buying the underlying growth index instead of investing in the fund.
Now, say a fund returned 5% in a year when the market returned 10%. You might initially think this fund underperformed the market. But, of course, you now know there's more to the situation than meets the eye. Let's say you discover that the fund's alpha was 5%. This means that nearly all of the fund's returns were attributable to the manager's skill. In this instance, sophisticated investors would 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 market conditions).
You now know that when it comes to evaluating investment strategies, absolute performance isn't the best indicator. 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 because it reveals how a fund performed relative to its risk level. It also reveals how much value a portfolio manager added to the strategy.
Alpha is actually the inspiration behind our name alphaAI. One of our main goals is to use AI to generate alpha for our clients!