Alpha
Alpha (α) is a term used in investing to describe an investment strategy's ability to beat the market, or its "edge." Alpha is thus also often referred to as “excess return” or the “abnormal rate of return” in relation to a benchmark, when adjusted for risk.
Alpha is often used in conjunction with beta (the Greek letter β), which measures the broad market's overall volatility or risk, known as systematic market risk.
Alpha is used in finance as a measure of performance, indicating when a strategy, trader, or portfolio manager has managed to beat the market return or other benchmark over some period. Alpha, often considered the active return on an investment, gauges the performance of an investment against a market index or benchmark that 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. Alpha may be positive or negative and is the result of active investing. Beta, on the other hand, can be earned through passive index investing.
Alpha (α)
Definition
Alpha (α) is a term used in investing to describe a strategy's ability to beat the market or its 'edge.' Therefore, alpha is also often referred to as 'excess return' or 'abnormal rate of return,' adjusted for risk. Alpha is typically used in conjunction with beta (β, the Greek letter β), which measures the overall market's volatility or risk, known as systematic market risk.
Origin
The concept of alpha originated from Modern Portfolio Theory (MPT), introduced by Harry Markowitz in 1952. Later, William Sharpe further developed the Capital Asset Pricing Model (CAPM) in 1964, where alpha became a widely used metric for assessing investment performance.
Categories and Characteristics
Alpha can be categorized into positive alpha and negative alpha. Positive alpha indicates that the investment strategy has successfully outperformed the market benchmark, achieving excess returns; negative alpha indicates that the strategy has underperformed the market benchmark. Characteristics of alpha include:
- Performance measure of active investment: Alpha is primarily used to evaluate the effectiveness of fund managers or investment strategies.
- Risk-adjusted return: Alpha takes into account the risk level of the investment, providing a more comprehensive performance assessment.
- Relative to benchmark performance: Alpha represents the excess return relative to a market benchmark, usually expressed as a percentage.
Specific Cases
Case 1: Suppose a fund manager's fund achieved a 12% return in one year, while the market benchmark index returned 8% during the same period. If the fund's beta is 1.1, indicating higher risk than the market average, the alpha is calculated as 12% - (8% * 1.1) = 3.2%. This means the fund manager successfully achieved a 3.2% excess return after adjusting for risk.
Case 2: Another fund manager's fund achieved a 5% return in one year, while the market benchmark index returned 7% during the same period. If the fund's beta is 0.9, indicating lower risk than the market average, the alpha is calculated as 5% - (7% * 0.9) = -1.3%. This means the fund manager failed to beat the market benchmark after adjusting for risk, underperforming expectations.
Common Questions
1. What is the difference between alpha and beta?
Alpha measures the excess return of an investment strategy, while beta measures the investment's volatility or systematic risk relative to the market.
2. Why can alpha be negative?
Negative alpha indicates that the investment strategy failed to beat the market benchmark, underperforming expectations. This could be due to changing market conditions, poor investment decisions, or other factors.
