Alpha is a term used to describe an investment strategy’s ability to beat the market or its edge. Often referred to as excess return or abnormal rate of return, alpha is used to measure performance and as an indicator of when a strategy, trader or portfolio manager has beat the market return over a period.
Alpha can also be used to gauge the performance of an investment against a market index or benchmark that represents the market’s movement as a whole. For example, the excess return of an investment relative to the return of a benchmark index is the investments alpha.
Often used in conjunction with beta, which measures volatility or risk in the broad market, alpha is the result of active investing where beta can be gained through passive index investing.
How alpha works
As one of the five common technical investment risk ratios, active portfolio managers want to generate alpha in diversified portfolios to eliminate unsystematic risk. As a marker for performance of a portfolio relative to a benchmark, alpha is considered to determine the value that portfolio managers adds and subtracts from a fund’s return.
Other risk ratios that are used to help investors identify the risk-return profile of an investment include:
Alpha represents the return on an investment that is not a result of general market movement. An alpha of zero would indicate that the investment was tracking with the benchmark index and the manager has not added or lost any value compared to the broad market.
Commonly used to rank active mutual funds as well as other investments, alpha is often shown as a single number which can be positive or negative and represents a percentage measure of how the portfolio or fund is performing compared to the benchmark index. For example, an alpha of +3.0 would show that it was performing 3% better than the benchmark index, and an alpha of -5.0 would represent it was performing 5% worse.
Advantages of alpha
The advantages of alpha include:
Can determine entry and exit points
Measuring alpha can help investors, traders and portfolio managers determine their entry and exit points on specified investments. Typically, they would look to enter when the alpha was negative, i.e. -5.0 and would look to exit when it was positive, i.e. +10.
Measure of performance
Alpha can give investors and fund managers a good overview of how their portfolios are performing against the rest of the market. It shows whether their portfolios are performing better, worse or perfectly tracking the benchmark index.
Disadvantages of alpha
The disadvantages of alpha include:
Limited ability to calculate returns
Using alpha as a way to calculate returns has its limitations as it cannot be used to compare multiple investment portfolios or asset types as it is restricted to stock market investments.
Debate about accuracy
Not all financial analysts and fund managers trust the accuracy of measuring alpha. According to the efficient market hypothesis all securities are properly priced at all times, therefore there is no way to beat the market and alpha is not relevant.