What is alpha?

Alpha ($\alpha$) is a term used in investing to describe the ability of an investment strategy to beat the market, or its ’edge’. Alpha is also often referred to as ’excess return’ or ‘abnormal rate of return’, which refers to the idea that markets are efficient and therefore there is no way to systematically outperform the market as a whole. Alpha is often used in conjunction with beta (the Greek letter $\beta$), which measures the overall volatility or risk of the market, known as systematic market risk.

Alpha is used in finance as a measure of performance, indicating when a strategy, trader or portfolio manager has managed to beat the market return over a certain period. Alpha, often considered the active return on an investment, measures the performance of an investment relative to a market index or benchmark that is believed to represent the movement of the market as a whole.

The excess return of an investment over the return of 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 investment in an index.

Understanding alpha

Alpha is one of the five most popular technical investment risk indices. The others are beta, standard deviation, R-square and Sharpe ratio. They are all statistical measures used in modern portfolio theory (MPT). All of these indicators are intended to help investors determine the risk-return profile of an investment.

Active portfolio managers seek to generate alpha in diversified portfolios, with diversification aimed at eliminating unsystematic risk. Since alpha represents the performance of a portfolio relative to a benchmark, it is often considered the value that a portfolio manager adds to or subtracts from a fund’s return.

In other words, alpha is the return on an investment that is not the result of a general market movement. Therefore, an alpha of zero would indicate that the portfolio or fund is tracking the benchmark index perfectly and that the manager has not added or subtracted any additional value from the general market.

The concept of alpha has become more popular with the advent of smart beta index funds linked to indices such as the Standard & Poor’s 500 index and the Wilshire 5000 Total Market Index. These funds seek to improve the performance of a portfolio that tracks a targeted subset of the market.

Despite the considerable desirability of alpha in a portfolio, many benchmark indices manage to outperform asset managers in the vast majority of cases. Due in part to the growing mistrust of traditional financial advice as a result of this trend, more and more investors are turning to low-cost, passive online advisors (often called roboadvisors) who exclusively or almost exclusively invest clients’ capital in index funds, on the grounds that if they cannot beat the market, they can.

Moreover, since most ’traditional’ financial advisors charge a fee, when one manages a portfolio and gets zero alpha, it actually represents a slight net loss for the investor. For example, suppose Jim, a financial advisor, charges 1% of the value of a portfolio for his services and during a 12-month period Jim managed to produce an alpha of 0.75 for the portfolio of one of his clients, Frank. Although Jim actually contributed to the performance of Frank’s portfolio, the fee Jim charges is greater than the alpha he generated, so Frank’s portfolio suffered a net loss. For investors, the example highlights the importance of looking at fees alongside returns and alpha.

The efficient market hypothesis (EMH) postulates that market prices incorporate all available information at all times and therefore securities are always priced correctly (the market is efficient).

If incorrect prices are identified, they are quickly arbitraged and thus persistent patterns of market anomalies that can be taken advantage of tend to be few and far between.

Empirical evidence comparing the historical returns of active mutual funds against their passive benchmarks indicates that less than 10 per cent of all active funds are able to achieve positive alpha over a period of more than 10 years, and this percentage drops once taxes and fees are taken into account. In other words, alpha is difficult to achieve, especially after taxes and fees.

Since beta risk can be isolated by diversification and hedging various risks (which entails various transaction costs), some have proposed that alpha does not really exist, but simply represents compensation for taking on an unhedged risk that had not been identified or had been overlooked.

In search of investment alpha

Alpha is commonly used to classify active mutual funds and all other types of investments. It is often represented as a single number (such as +3.0 or -5.0), which usually refers to a percentage measuring the performance of the portfolio or fund relative to the benchmark index (e.g. 3% better or 5% worse).

A more in-depth analysis of alpha may also include ‘Jensen’s alpha’. Jensen’s alpha takes into account the market theory of the Capital Asset Pricing Model (CAPM) and includes a risk-adjusted component in its calculation. Beta (or beta coefficient) is used in the CAPM, which calculates the expected return of an asset based on its specific beta and expected market returns. Alpha and beta are used jointly by investment managers to calculate, compare and analyse returns.

The entire investment universe offers investors a wide range of securities, investment products and advisory options to consider. Different market cycles also influence the alpha of investments in different asset classes. This is why risk-return metrics are important to consider along with alpha.

Examples

This is illustrated in the following two historical examples of a fixed-income ETF and an equity ETF:

The iShares Convertible Bond ETF (ICVT) is a low-risk fixed income investment. It tracks a customised index called the Bloomberg U.S. Convertible Cash Pay Bond > $250MM Index. The 3-year standard deviation was 18.94%, as of 28 February 2022. The year-to-date return, as of 28 February 2022, was -6.67%. Over the same period, the Bloomberg U.S. Convertible Cash Pay Bond > $250MM index returned -13.17%. Thus, ICVT’s alpha was -0 12% compared to the Bloomberg U.S. Aggregate index and a 3-year standard deviation of 18.97%.

However, since the Aggregate Bond Index is not the correct benchmark for ICVT (it should be the Bloomberg Convertible Index), this alpha may not be as large as initially thought and, indeed, may be incorrectly attributed, since convertible bonds have much riskier profiles than plain vanilla bonds.

The WisdomTree U.S. Quality Dividend Growth Fund (DGRW) is a higher market risk equity investment that aims to invest in dividend growth stocks. Its holdings follow a customised index called the WisdomTree U.S. Quality Dividend Growth Index.

It has a three-year annualised standard deviation of 10.58%, which is higher than ICVT.

As of 28 February 2022, DGRW’s annualised return was 18.1%, also higher than that of the S&P 500 (16.4%), with an alpha of 1.7% over the S&P 500.

Again, however, the S&P 500 may not be the correct benchmark for this ETF, since dividend-paying growth stocks are a very particular subset of the overall stock market, and may not even include the 500 most valuable stocks in America.

Alpha considerations

Although alpha has been called the “holy grail” of investing and as such receives much attention from investors and advisors, there are a couple of important considerations to take into account when using alpha.

The basic alpha calculation subtracts the total return of an investment from a comparable benchmark in its asset class. This alpha calculation is primarily used only against a comparable category benchmark, as shown in the examples above. Therefore, it does not measure the outperformance of an equity ETF against a fixed income benchmark. Alpha is also best used when comparing the performance of similar investments. Therefore, the alpha of the DGRW equity ETF is not relatively comparable to the alpha of the ICVT fixed income ETF. Some references to alpha may refer to a more advanced technique. Jensen’s alpha takes into account CAPM theory and risk-adjusted measures using risk-free rate and beta. When using a calculation of the generated alpha, it is important to understand the necessary calculations. Alpha can be calculated using different benchmark indices within an asset class. In some cases, there may be no suitable pre-existing index, in which case advisors may use algorithms and other models to simulate an index for the purpose of comparative alpha calculation.

Alpha may also refer to the abnormal rate of return of a security or portfolio above that predicted by an equilibrium model such as CAPM. In this case, a CAPM model could aim to estimate returns for investors at various points along an efficient frontier. The CAPM analysis might estimate that a portfolio should earn 10% based on its risk profile. If the portfolio actually earns 15%, the portfolio’s alpha would be 5.0, or +5% over what the CAPM model predicts.

KEY RESULTS

• Alpha refers to the excess returns earned by an investment over the benchmark return.
• Active portfolio managers seek to generate alpha in diversified portfolios, with diversification aimed at eliminating unsystematic risk.
• Since alpha represents the performance of a portfolio relative to a benchmark, it is often considered the value a portfolio manager adds to or subtracts from a fund’s return.
• Jensen’s alpha takes the Capital Asset Pricing Model (CAPM) into account and includes a risk-adjusted component in its calculation.

Source: www.investopedia.com