Thursday, 14th December 2017
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John Smiles

Qualified Financial Advisor

In investment terms, what is Alpha?

When discussing investment strategy, investment fund managers and analysts talk about alpha and beta.

Beta is defined as the element of investment return or portfolio returns that can be explained by market risk, or by exposure of the investment to the market. This is the return any investor would expect to receive from the market just for being invested.

Most investors seek to get the highest return possible on their investments for the least amount of risk. This extra return above the beta can be measured by alpha. Alpha is understood to be a measurable way to determine whether a manager's skill has added value to a fund on a risk-adjusted basis.

The very existence of alpha is controversial, however, because those who believe in the efficient market hypothesis (which says, among other things, that it is impossible to beat the market) attribute alpha to luck instead of skill and base this belief on the fact that most managers fail to beat the market over the long-term.

Alpha is the rate of return that exceeds what was expected or predicted by models like the capital asset pricing model (CAPM). The main part of the CAPM formula calculates what the rate of return on a certain security or portfolio ought to be under certain market conditions.

In a theoretical portfolio, if the fund manager expects the market to grow by 10% and the portfolio returns a growth of 12%, the alpha of the portfolio = 12% – 10% = 2%.

Alpha is also known as "excess return" or "abnormal rate of return," and is one of the most widely used measures of risk-adjusted performance. The number shows how much better or worse a fund performed relative to a benchmark. This difference is then attributed to the decisions made by the fund's management.

Two similar portfolios might carry the same amount of risk (same beta) but because of different alphas, it's possible for one to generate higher returns than the other. This is a fundamental quandary for investors, who always want the highest return for the least amount of risk.

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