Alpha
Alpha is used to measure performance.
Gauges the performance of an investment against a market index or benchmark which is considered to represent the market’s movement as a whole.
The excess return of an investment relative to the return of a benchmark index is the investment’s alpha.
How is Alpha measured
Alpha is often represented as a single number (eg. 3 or -5), but this refers to a percentage measuring how the portfolio or fund performed compared to the benchmark index (i.e. 3% better or 5% worse).
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 value.
Alpha Cont
Alpha is often used in conjunction with beta, which measures volatility or risk. Alpha is also often referred to as “excess return” or “abnormal rate of return.”
Alpha Cont
Because alpha represents the performance of a portfolio relative to a benchmark, it is often considered to represent the value that a portfolio 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 general movement in the greater market
Alpha and Fees
As most “traditional” financial advisers charge a fee, when one manages a portfolio and nets an alpha of zero, it represents a slight net loss for the investor.
For example, suppose the adviser, charges 1% of a portfolio’s value for his services and that during a 12-month period produced an alpha of 0.75. While the adviser has helped the performance of the portfolio, the fees are in excess of the alpha generated, so there’s a net loss.
Alpha Considerations
- 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. Therefore it does not measure the out-performance of one asset against another unless comparing performance of similar asset investments.
- 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 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 advisers may use algorithms and other models to simulate an index for 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 equilibrium model like CAPM. In this instance, a CAPM model might aim to estimate returns for investors at various points along an efficient frontier. The CAPM analysis might estimate that a portfolio should earn 10% based on the portfolio’s risk profile. If the portfolio actually earns 15%, the portfolio’s alpha would be 5, or 5% over what was predicted in the CAPM model.
