Alpha (α) is a popular investment term that refers to the excess return of an investment in comparison to the benchmark index. It gauges an investment strategy’s ability to outperform the market, and it is particularly essential to active portfolio managers looking to generate alpha in diversified portfolios that minimize unsystematic risk. Alpha measures the value added or subtracted from a fund’s return by portfolio managers. Alpha is hard to come across in the real world. And recent studies suggest that it may not exist at all, and instead, it simply represents a reward for taking on some unknown or overlooked risk that hasn’t been hedged.
Alpha (α) is the term used in the investment world to describe an investment strategy’s ability to outperform the market, known as its “edge.” It refers to the “excess return” or “abnormal rate of return” earned beyond the broad market’s return.
Alpha is used to gauge whether a trading strategy, trader, or portfolio manager has managed to beat the market return over a specific period. It is considered the active return on an investment and is gauged against a market index or benchmark. Alpha works hand in hand with beta (β), which measures the broad market’s overall risk, known as systematic market risk.
The excess return of an investment relative to the return of a benchmark index is considered the investment’s alpha. The Alphaof an investment can be either positive or negative, and it results from active investing, while beta can be earned through passive index investing.
Alpha is one of the most popular investment risk ratios used today. It’s one of the five most important technical indicators, which include beta, standard deviation, R-squared, and the Sharpe ratio, used in modern portfolio theory to help investors evaluate the risk and return of an investment.
Active portfolio managers aim to generate alpha in diversified portfolios, which are designed to minimize unsystematic risk. Alpha is particularly important because it represents a portfolio’s performance compared to a benchmark. Essentially, it shows whether the portfolio manager has added or subtracted value from the fund’s return compared to the market as a whole.
When the alpha is zero, it means that the portfolio is tracking the benchmark index exactly and the manager has not added any extra value to the portfolio. So, in order to have a successful portfolio, investors want a positive alpha.
What does alpha measure?
Alpha, the measure of an investment’s performance relative to a benchmark index, has gained popularity in recent years with the rise of smart beta index funds. These funds aim to outperform a particular segment of the market by using a variety of strategies, such as value or momentum investing. However, despite the allure of alpha, many investors have lost faith in traditional financial advisors who often charge high fees for their services, while failing to consistently beat the market.
As a result, more and more investors are turning to roboadvisors, which use algorithms to invest clients’ capital into low-cost index-tracking funds. The rationale is that if they can’t beat the market, they may as well join it. This shift towards passive investing highlights the importance of fees when evaluating a portfolio’s performance.
Even if a financial advisor manages to generate alpha, if their fees exceed that amount, the investor may experience a net loss. Here is an example, you’ve hired a financial advisor named Jim to manage your investments. Jim charges 1% of your portfolio’s value as a fee for his services. Over the course of a year, Jim manages to produce an alpha of 0.75 for your portfolio. That sounds great, right? But here’s the catch: because Jim charges a fee, an alpha of zero or even a positive alpha-like 0.75 can actually result in a net loss for you. In Frank’s case, Jim’s fee was in excess of the alpha he generated, meaning that Frank’s portfolio experienced a net loss despite Jim’s efforts. This example emphasizes the importance of not only looking at performance returns and alpha but also considering fees when choosing a financial advisor. After all, you want your portfolio to be growing, not shrinking due to fees.
The efficient market hypothesis
The Efficient Market Hypothesis (EMH) is a theory that suggests that market prices reflect all available information and are always accurately priced. In other words, the market is efficient. As a result, it is challenging to identify mispricings in the market and profit from them because they don’t exist for very long. Any mispricings that do occur are usually quickly corrected through arbitrage, making it difficult to find persistent patterns of market anomalies to take advantage of. This hypothesis is important for investors to consider when deciding whether to pursue active or passive investment strategies, as it suggests that consistently outperforming the market may be difficult or even impossible.
Recent studies have shown that fewer than 10% of active funds are actually able to generate a positive alpha over a period of 10 years or more. And even that small percentage dwindles once you factor in the additional taxes and fees you have to pay. Needless to say, alpha is hard to come across. Some experts suggest that it may not even exist. Instead, it simply represents the reward for taking on some unknown or overlooked risk that hasn’t been hedged
Searching for Alpha
Alpha is a popular way to evaluate the performance of investments, including active mutual funds, and is often presented as a single number that represents the excess return (positive or negative) compared to the benchmark index. But did you know that there’s more to alpha than just a simple percentage? That’s where Jensen’s alpha comes in – it considers risk-adjustment in its calculation, taking into account the capital asset pricing model (CAPM) market theory.
Beta is an essential component of the CAPM and measures the expected return of an asset compared to the expected market returns. Investment managers use alpha and beta together to analyze, compare, and calculate returns.
The investment world is big, and there are various investment options and advisory services for investors to choose from. Different market cycles also affect the alpha of investments in different asset classes, making it essential to consider risk-return metrics along with alpha. So, if you’re seeking investment alpha, it’s important to understand how it’s calculated, what factors influence it, and how it fits into your overall investment strategy.
Examples of Alpha in ETFs
Alpha is an important metric to evaluate the performance of ETFs. Let’s take a look at two examples:
The iShares Convertible Bond ETF (ICVT) tracks the Bloomberg U.S. Convertible Cash Pay Bond > $250MM Index.
As of Feb. 28, 2022, its year-to-date return was -6.67%, while the benchmark had a return of -13.17% over the same period, resulting in an alpha of -0.12%. However, since the benchmark should be the Bloomberg Convertible Index instead of the aggregate bond index, the alpha may not be as significant as initially thought.
WisdomTree U.S. Quality Dividend Growth Fund
The WisdomTree U.S. Quality Dividend Growth Fund (DGRW) invests in dividend growth equities and tracks the WisdomTree U.S. Quality Dividend Growth Index. As of Feb. 28, 2022, its annualized return was 18.1%, higher than the S&P 500’s 16.4%, resulting in an alpha of 1.7%. However, the S&P 500 may not be the appropriate benchmark for this ETF, as it invests in a specific subset of the overall stock market.
What considerations should you make when using alpha
Alpha is a popular metric that measures the outperformance of an investment compared to its benchmark. However, it’s important to use alpha only against a comparable benchmark in the same asset category, and not to compare it across different asset categories. Jensen’s alpha is a more advanced technique that considers risk-adjusted measures using the risk-free rate and beta. Alpha can be calculated using various benchmarks within an asset class, but if no suitable index exists, advisors may use algorithms to simulate one for comparative purposes.
Have you ever heard of the term “alpha”? It’s a measure of a security or portfolio’s performance that goes beyond what would be expected based on traditional analysis. For example, let’s say a portfolio is expected to earn a 10% return based on its risk profile, according to the widely-used CAPM model. But if it actually earns 15%, then it has an alpha of 5.0 or +5% over what was predicted by the model. This can be a sign that the investment manager has made smart decisions or taken risks that paid off. It’s like finding a hidden treasure in the market!
- Alpha is the excess return earned on an investment above the benchmark return.
- Active portfolio managers aim to generate alpha in diversified portfolios to eliminate unsystematic risk.
- It represents the value that a portfolio manager adds to or subtracts from a fund’s return.
- Jensen’s alpha is a more advanced technique that will consider the capital asset pricing model (CAPM) and includes a risk-adjusted component in its calculation.
View Article Sources
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Allan Du is a personal finance writer passionate about helping people take control of their finances. Allan strives to present readers with the right knowledge and tools, so they can make informed decisions about their money and build wealth. When he is not writing about finance, Allan enjoys pursuing his other interests, including powerlifting, kickboxing, and investing. He is an active follower of economic and political trends, always keeping watch on the latest developments that could impact the financial world.