Alpha: What It Means in Investing, With Examples
The ability of an investment strategy to outperform the market or its “edge,” is referred to in the investing world as alpha (). Thus, when risk is considered, alpha is frequently referred to as “excess return” or the “abnormal rate of return” about a benchmark. The Greek letter beta, which represents the total volatility or risk of the broad market (sometimes referred to as systematic market risk), is frequently employed in conjunction with alpha.
When a strategy, trader, or portfolio manager outperforms the market return or another benchmark over a set period, it is shown by using the performance metric alpha in the financial industry. The performance of an investment is measured against a market index or benchmark that is thought to reflect the movement of the market as a whole accurately. Alpha is frequently referred to as the active return on an investment.
The alpha of an investment is its excess return over the return of a benchmark index. The outcome of active investing is alpha, which can be either positive or negative. Conversely, passive index investment can be used to earn beta.
One of the five widely used technical investment risk ratios is alpha alpha. Beta, standard deviation, R-squared, and the Sharpe ratio round out the list. Modern portfolio theory (MPT) employs all of these statistical evaluations. Investors can use any or all of these indicators to assess an investment’s risk-return profile.
Diversification reduces unsystematic risk, while active portfolio managers aim to produce alpha in diverse portfolios. The value that a portfolio manager contributes to or subtracts from a fund’s return is sometimes represented by alpha, which measures a portfolio’s performance about a benchmark.
Alpha is the return on an investment that does not originate from a broad trend in the larger market. As a result, an alpha of zero would mean that the portfolio or fund is perfectly mirroring the benchmark index and that the management has not gained or lost any additional value throughout the general market.
Using Alpha in Investment
With the introduction of smart beta index funds linked to indexes like the Standard & Poor’s 500 index and the Wilshire 5000 Total Market Index, alpha gained more traction. These funds try to improve a portfolio’s performance while tracking a specific market segment.
Even though alpha is highly desirable in a portfolio, several index benchmarks consistently outperform asset managers. More and more investors are switching to low-cost, passive online advisors (often called roboadvisors) who exclusively or almost exclusively invest clients’ money into index-tracking funds, reasoning that if they can’t beat the market, they might as well join it. This shift is partly due to a growing lack of faith in traditional financial advising brought about by this trend.
In addition, because the majority of “traditional” financial advisors charge a fee, managing a portfolio with a net alpha of zero results in a slight net loss for the investor. If Jim, a financial adviser, charges 1% of the value of a portfolio for his services, let’s say that over a year, Jim was able to generate an alpha of 0.75 for the portfolio of one of his clients, Frank.
Frank’s portfolio has performed better, thanks to Jim. Still, because Jim charges a fee more than the alpha he produces, Frank’s portfolio has suffered a net loss. The example serves as a reminder to investors of the significance of taking fees into account in addition to performance returns and alpha.
Effective Market Theory
According to the Efficient Market Hypothesis (EMH), since market prices always take into account all information that is accessible, securities are always priced correctly (the market is efficient). The EMH contends that since there are no market mispricings, it is impossible to find and profit from them systematically.
Mispricings are swiftly removed through arbitrage if they are found. Therefore, very few lasting patterns of market anomalies can often be exploited.
Fewer than 10% of all active funds can achieve a positive alpha over a 10-year or longer period, and this number declines after taxes and fees are taken into account, according to empirical data comparing historical returns of active mutual funds about their passive benchmarks. Alpha is, therefore, difficult to find, especially after taxes and fees.
A claim that alpha does not exist and is merely the reward for assuming an unidentified or unconsidered unhedged risk. Beta risk can be isolated by diversifying and hedging different risks (which have a variety of transaction costs).
The ranking of active mutual funds and all other investment kinds is frequently done using the alpha metric. It is sometimes expressed as a single figure (such as +3.0 or -5.0), which usually denotes a percentage reflecting how the portfolio or fund performed compared to the cited benchmark index (i.e., 3% better or 5% worse).
“Jensen’s alpha” may also be included in a more thorough investigation of alpha. Jensen’s alpha has a risk-adjusted component and is calculated using the capital asset pricing model (CAPM) market theory. The CAPM, which determines an asset’s projected return based on its unique beta and the anticipated market returns, uses beta (or the beta coefficient). Investment managers combine alpha and beta to compute, contrast, and evaluate returns.
A wide variety of assets, investment products, and advising alternatives are available to investors across the board in the investing world. Different market cycles also impact the alpha of investments across various asset classes. This is why risk-return measures should be considered in addition to alpha.
The following two historical instances of an equities ETF and a fixed-income ETF serve to illustrate this point:
A low-risk fixed-income investment is the iShares Convertible Bond ETF (ICVT). It follows the Bloomberg U.S. Convertible Cash Pay Bond > $250MM Index, a specialized index. As of February 28, 2022, the 3-year standard deviation was 18.94%. As of February 28, 2022, the return for the year has been -6.67%. Over the same period, the Bloomberg U.S. Convertible Cash Pay Bond > $250MM Index returned -13.17%. With a 3-year standard deviation of 18.97% and an alpha of 6.5% compared to the Bloomberg U.S. Aggregate Index, ICVT performed well.
The Bloomberg Convertible index should be used as the benchmark for ICVT instead of the aggregate bond index. Therefore, this alpha may not be as significant as first thought. It may have been misattributed because convertible bonds have far higher risk profiles than standard bonds.
A higher market risk equity investment that tries to invest in dividend growth stocks is the WisdomTree U.S. Quality Dividend Growth Fund (DGRW). Its holdings follow the WisdomTree U.S. Quality Dividend Growth Index, a specialized index. It was more variable than ICVT, with a three-year annualized standard deviation of 10.58%.
DGRW had an alpha of 1.7% compared to the S&P 500 as of February 28, 2022, with an annualized return of 18.1%, higher than the S&P 500’s 16.4% return. Although dividend-paying growth stocks are a highly specific subset of the wider stock market, the S&P 500 may not even include America’s 500 most valuable stocks. Thus, it may not be the best benchmark for this ETF.
Considerations for Alpha
Although alpha has been referred to as the “holy grail” of investing and, as such, it attracts a lot of interest from both investors and advisors, there are a few key factors that one should keep in mind when employing alpha.
The total return of an investment is subtracted from a benchmark equivalent in its asset class to calculate alpha. As mentioned in the examples above, this alpha calculation is typically only utilized against a benchmark for a comparable asset class. As a result, it does not reflect an equity ETF’s superiority over a fixed-income benchmark. This alpha is also best used when comparing the performance of assets in similar asset classes. As a result, the equities ETF DGRW’s alpha is not comparable to the fixed-income ETF ICVT’s alpha.
Alpha sometimes refers to a more sophisticated method. Jensen’s alpha considers CAPM theory and risk-adjusted metrics using the risk-free rate and beta.
Comprehending the calculations involved when employing a produced alpha calculation is crucial. An asset class’s numerous index benchmarks can be used to compute alpha. There could not always be an appropriate pre-existing index, so advisors might simulate an index using algorithms and other models to calculate comparative alpha.
A portfolio’s or security’s abnormal rate of return over that expected by an equilibrium model like the CAPM is known as alpha. A CAPM model might be used to forecast investor returns along an efficient frontier in this situation. Based on the portfolio’s risk profile, the CAPM analysis might predict that the portfolio should earn 10%. If the portfolio truly makes 15%, its alpha would be 5.0, 5% more than the CAPM model projected.
What in Finance Are Alpha and Beta?
While beta is the measure of volatility, commonly known as risk, alpha is the excess return over a benchmark for an investment. Active investors use cutting-edge tactics to generate alpha returns.
What Exactly Is a Good Financial Alpha?
What is a decent alpha in finance, specifically in trading and investing, varies depending on the investor’s objective and risk tolerance. A decent alpha is typically more than zero when risk is considered.
What Does a Stock’s Negative Alpha Mean?
When a stock’s performance is adjusted for risk, it is said to have a negative alpha, underperforming the benchmark. An investor’s alpha is negative if they want to match or outperform a particular benchmark, yet their investment portfolio underperforms it.
An investor’s objective is to generate the highest profits feasible. When adjusted for risk, alpha represents a performance metric for investment returns that outperforms a benchmark. Active investors can use several methods to outperform a benchmark regarding returns. Many funds, including hedge funds, aim to achieve alpha, and they do so by charging hefty management fees.
- When risk is considered, alpha is the excess return on an investment earned over the benchmark return.
- Diversification reduces unsystematic risk, while active portfolio managers aim to produce alpha in diverse portfolios.
- The value that a portfolio manager contributes to or subtracts from a fund’s return is sometimes represented by alpha, which measures a portfolio’s performance about a benchmark.
- The capital asset pricing model (CAPM) and a risk-adjusted component are considered in the computation of Jensen’s alpha.