What Is Alpha?

What Is Alpha?

Let me tell you about alpha in investing. Alpha, denoted by the Greek letter α, describes an investment strategy's ability to beat the market, which we often call its 'edge.' It's essentially the excess return or abnormal rate of return compared to a benchmark, all adjusted for risk.

You'll often see alpha used alongside beta, which is the Greek letter β and measures the overall volatility or systematic risk of the broad market.

In finance, alpha serves as a performance measure, showing when a strategy, trader, or portfolio manager has outperformed the market return or another benchmark over a period. Think of alpha as the active return on an investment, evaluating how it performs against a market index that represents the market's overall movement.

The excess return of an investment over the benchmark index's return is its alpha. This can be positive or negative and comes from active investing, unlike beta, which you can get through passive index investing.

Understanding Alpha

Alpha is one of five key technical risk ratios in investing, along with beta, standard deviation, R-squared, and the Sharpe ratio. These are statistical tools from modern portfolio theory that help you determine an investment's risk-return profile.

As an active portfolio manager, you would aim to generate alpha in diversified portfolios to cut out unsystematic risk. Alpha shows the performance relative to a benchmark, so it essentially measures the value you add or subtract from a fund's return.

Put simply, alpha is the return on an investment that doesn't come from general market movements. An alpha of zero means the portfolio or fund tracks the benchmark perfectly, with no added or lost value from the manager compared to the broad market.

Applying Alpha to Investing

The idea of alpha gained popularity with smart beta index funds linked to indexes like the S&P 500 or Wilshire 5000. These funds try to boost performance by tracking a specific market subset.

Even though alpha is highly desirable, most index benchmarks outperform asset managers most of the time. This has led to a loss of faith in traditional advising, pushing more investors toward low-cost, passive robo-advisors that mainly use index-tracking funds—if you can't beat the market, join it.

Traditional advisors charge fees, so if you manage a portfolio with an alpha of zero, it's actually a slight net loss for the investor. Take Jim, a financial advisor charging 1% on a portfolio's value. Over 12 months, he generates an alpha of 0.75 for client Frank. While Jim improved the portfolio, his fee exceeds the alpha, resulting in a net loss for Frank. This shows you why fees matter alongside returns and alpha.

Efficient Market Hypothesis

The efficient market hypothesis (EMH) states that market prices always reflect all available information, so securities are properly priced and the market is efficient. Under EMH, you can't systematically spot and exploit mispricings because they don't exist.

If mispricings appear, they're quickly arbitraged away, making persistent anomalies rare.

Historical data on active mutual funds versus passive benchmarks shows fewer than 10% earn positive alpha over 10+ years, dropping further with taxes and fees. Alpha is tough to achieve, especially after costs. Some argue alpha doesn't exist but compensates for unidentified unhedged risks.

Seeking Investment Alpha

We commonly use alpha to rank active mutual funds and other investments. It's often a single number like +3.0 or -5.0, showing percentage outperformance or underperformance against a benchmark index.

For deeper analysis, consider Jensen's alpha, which uses CAPM and includes risk adjustment with the risk-free rate and beta. Beta in CAPM calculates expected returns based on an asset's beta and market returns. Managers use alpha and beta to calculate, compare, and analyze returns.

The investing world offers various securities, products, and advice, with market cycles affecting alpha across asset classes. That's why you should consider risk-return metrics with alpha.

Example of Alpha

Let me give you two historical examples: one for a fixed-income ETF and one for an equity ETF.

The iShares Convertible Bond ETF (ICVT) is a low-risk fixed-income investment tracking the Bloomberg U.S. Convertible Cash Pay Bond > $250MM Index. As of Feb. 28, 2022, its three-year standard deviation was 18.94%, with a year-to-date return of -6.67%. The index returned -13.17% over the same period, giving ICVT an alpha of 6.5% versus the Bloomberg U.S. Aggregate Index (standard deviation 18.97%). But since the aggregate index isn't the right benchmark—convertibles are riskier—this alpha might be overstated or misattributed.

The WisdomTree U.S. Quality Dividend Growth Fund (DGRW) is a higher-risk equity investment tracking its own index. It had a three-year annualized standard deviation of 10.58%. As of Feb. 28, 2022, its annualized return was 18.1%, beating the S&P 500's 16.4% for an alpha of 1.7%. Again, the S&P 500 might not be ideal, as dividend growth stocks are a specific subset.

Alpha Considerations

Alpha is often called the 'holy grail' of investing and gets a lot of attention, but keep a few things in mind when using it.

Basic alpha subtracts an investment's total return from a comparable benchmark in its category. Use it only against similar benchmarks—it doesn't compare equity ETFs to fixed-income ones. So, the alpha of equity ETF DGRW isn't comparable to fixed-income ICVT.

Some alpha references use advanced techniques like Jensen's, incorporating CAPM with risk-free rate and beta.

Understand the calculations: alpha uses various benchmarks within an asset class. If no suitable index exists, advisors might simulate one. Alpha can also mean excess return over CAPM predictions. For example, if CAPM predicts 10% but the portfolio earns 15%, alpha is +5%.

What Are Alpha and Beta in Finance?

Alpha measures excess return above a benchmark, while beta measures volatility or risk. Active investors use unique strategies to achieve alpha returns.

What Is a Good Alpha in Finance?

A good alpha varies by your goals and risk tolerance, but generally, it's greater than zero when risk-adjusted.

What Does a Negative Alpha Mean in Stocks?

Negative alpha means the stock underperforms its benchmark when adjusted for risk. If you're aiming to match or beat a benchmark and fall short, your alpha is negative.

The Bottom Line

Your goal as an investor is to maximize returns. Alpha measures performance that's better than a benchmark, adjusted for risk. Active investors aim for higher returns using various strategies. Funds like hedge funds target alpha and charge high fees for it.