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Alpha (alpha) is a term used in investing to describe a certain investment strategy's ability, or "edge," to outperform the market.
Alpha (alpha) is a term used in investing to describe a certain investment strategy's ability, or "edge," to outperform the market. Therefore, alpha is often referred to as excess return or abnormal return relative to a benchmark, when compared after adjusting for risk.
Alpha is often used in conjunction with beta, which measures the overall volatility or risk of a broad market, often referred to as systemic market risk.
In finance, alpha is viewed as a measure of performance that indicates whether a strategy, trader or portfolio manager is able to beat market returns or other benchmarks over a certain period of time. Alpha is typically viewed as an investment's active return and evaluates an investment's performance relative to a market index or benchmark that is believed to represent the overall movement of the market.
The excess return of an investment relative to a benchmark index is the investment's alpha. Alpha can be positive or negative and is the result of active investing. Beta, on the other hand, can be obtained through passive index investing.
Alpha is one of five common technical investment risk ratios, the other four being beta, standard deviation, coefficient of determination (R-squared), and Sharpe ratio. These are statistical indicators used in Modern Portfolio Theory (MPT) to help investors determine the risk-return characteristics of an investment.
Active portfolio managers want to generate alpha in a diversified portfolio that aims to eliminate unsystematic risk. Alpha reflects a portfolio's performance relative to a benchmark and is therefore often viewed as the portfolio manager's gain or loss in value to the fund's returns.
In other words, alpha is the portion of investment income that is not affected by the overall movement of the market. Therefore, an alpha of zero means that the portfolio or fund is completely tracking the benchmark index and the manager fails to add or subtract additional value to it.
The concept of alpha is gaining traction with the rise of smart beta index funds, which are tied to indexes such as the S&P 500 and the Wilshire 5000 Total Market Index. These funds attempt to enhance the performance of a portfolio that tracks a specific subset of the market.
While alpha is not negligible in a portfolio, many index benchmarks still outperform asset managers the vast majority of the time. Partly due to a trend of losing faith in traditional financial advisors, more and more investors are turning to low-cost, passive online advisors (often called robo-advisors) who put almost or all of their clients' assets into index-tracking funds, believing that if they can't beat the market, they'll just follow it.
Additionally, due to the fees most traditional financial advisors charge, when a manager manages a portfolio and earns zero alpha, it actually represents a slight net loss to the investor. For example, let's say a financial advisor named Jim charges clients 1% of the value of their portfolios. Over a 12-month period, the portfolio Jim manages for his client Frank generates an alpha of 0.75.
While Jim did improve the performance of Frank's portfolio, he charged more fees than he created alpha, so Frank's portfolio experienced some net loss. This example highlights the importance of fees when considering performance returns and alpha.
The efficient market hypothesis (EMH) assumes that market prices absorb all available information at all times, so securities are always priced rationally (the market is efficient). Therefore, according to the EMH, it is impossible to systematically identify and exploit mispricings in the market because such pricing itself does not exist.
If mispricing is discovered, markets are quick to arbitrage corrections, so persistent patterns of market anomalies that can be exploited are often rare.
An empirical analysis of historical active mutual fund returns versus their passive benchmarks shows that over 10 years, less than 10% of active funds have achieved positive alpha, and this proportion decreases even further after taxes and fees are taken into account. In other words, alpha isn't easy to come by, especially after taxes and fees.
Since beta risk can be isolated by diversifying and hedging different risks (which comes with various transaction costs), some have proposed that alpha does not actually exist but is the compensation that comes with certain unhedged or overlooked risks.
Alpha is commonly used to rank active mutual funds and other types of investments. It is usually expressed as a single number (such as +3.0 or -5.0) and usually refers to a measure of the performance of a portfolio or fund compared to a reference benchmark index (i.e., the percentage of performance that is better or worse than the benchmark).
An in-depth analysis of alpha may also include Jensen’s alpha. Jensen's alpha considers the Capital Asset Pricing Model (CAPM) market theory and includes a risk-adjusted component in its calculation. Beta (or beta coefficient) is used in CAPM, which calculates expected returns based on an asset's specific beta and expected market returns. Investment managers use alpha and beta together to calculate, compare and analyze returns.
The entire investment universe offers a wide range of securities, investment products and advisory options for investors to consider. Different market cycles also have an impact on the alpha of investments in different asset classes. Therefore, risk-return metrics are particularly important when considering alpha.
Alpha is demonstrated in the following two historical examples of fixed income exchange-traded funds (ETFs) and equity ETFs:
The iShares Convertible Bond ETF (ICVT) is a low-risk fixed-income investment. It tracks a custom index called the "Bloomberg U.S. Convertible Cash Payable Bonds > 250MM Index." As of February 28, 2022, its three-year standard deviation was 18.94%. As of the same date, its year-to-date return was -6.67%. The Bloomberg U.S. Convertible Cash Payable Bonds > 250MM Index gained -13.7% during the same period. Therefore, compared to the Bloomberg US Aggregate Index, ICVT's alpha is 6.5% and its three-year standard deviation is 18.97%.
However, since the Aggregate Bond Index is not an appropriate benchmark for ICVT (the correct benchmark would be the Bloomberg Convertible Bond Index), the size of this alpha may be overestimated; indeed, it may be misattributed since convertible bonds have much higher risk characteristics than ordinary bonds.
The WisdomTree U.S. Quality Dividend Growth Fund (DGRW) is a higher-risk equity investment designed to invest in dividend growth stocks. Its holdings track a custom index called the WisdomTree U.S. Quality Dividend Growth Index. DGRW's annualized return as of February 28, 2022 was 18.1%, also higher than the S&P 500's 16.4%, resulting in an alpha compared to the S&P 500 of 1.7%. But again, the S&P 500 may not be the right benchmark for this ETF, since dividend-paying growth stocks are a specific subset of the overall stock market and don't necessarily even include the top 500 most valuable companies in the United States.
Although alpha is known as the "holy grail" of investing and therefore receives a lot of attention from investors and advisors, there are several important factors that should be considered when using alpha.
When using generated alpha calculations, it is important to understand the calculations involved. Alpha can be calculated across a number of different benchmark indexes within an asset class. In some cases, a suitable pre-existing benchmark may not be available, in which case the consultant may use algorithms and other models to simulate the benchmark for the purpose of comparative alpha calculations.
Alpha can also refer to the abnormal return of a security or portfolio that exceeds the return predicted based on an equilibrium model such as the CAPM. In this case, the CAPM may be designed to estimate investor returns at different points on the efficient frontier. If a portfolio actually earned 15% and the CAPM estimated that the portfolio should have earned 10%, then the portfolio's alpha is 5.0, meaning it earned 5% more than what the CAPM predicted.
Alpha measures an investment's excess return compared to a benchmark, while beta is volatility, a measure of risk. Active investors use unique strategies to achieve alpha.
In finance, especially in trading and investing, what alpha is considered good will vary based on an investor's goals and risk tolerance. Typically, a good alpha is one that is greater than zero on a risk-adjusted basis.
Negative alpha in a stock means that the stock underperforms the benchmark after accounting for risk. If an investor hopes to match or beat a particular benchmark and his or her portfolio performs worse than that benchmark, its alpha will be negative.
The investor's goal is to achieve the highest possible return. Alpha is a measure of investment performance compared to a benchmark on a risk-adjusted basis. Active investors seek returns above their benchmark through different strategies. Many funds, such as hedge funds, aim to achieve alpha and charge higher management fees as a result.
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