Understanding Alpha

Simply stated, alpha is often considered to represent the value that a portfolio manager adds to or subtracts from a fund’s return

Alpha is one of five technical risk ratios; the others are beta, standard deviation, R-squared, and the Sharpe ratio. These are all statistical measurements used in modern portfolio theory (MPT). All of these indicators are intended to help investors determine the risk-reward profile of a mutual fund. Alpha can be used in the following ways:

1. A measure of performance on a risk-adjusted basis. Alpha takes the volatility (price risk) of a mutual fund and compares its risk-adjusted performance to a benchmark index. The excess return of the fund relative to the return of the benchmark index is a fund’s alpha.

2. The abnormal rate of return on a security or portfolio in excess of what would be predicted by an equilibrium model like the capital asset pricing model (CAPM).

For an investment to be considered pure alpha, its returns must be completely independent from the returns attributed to beta. Some portfolio managers use their alpha portfolios to buy individual equities. This method is not pure alpha, but rather the manager’s skill in equity selection. This creates a positive alpha return, but it is what is referred to as “tainted alpha”. It is tainted because of the consequential beta exposure that goes along with the purchase of the individual equity, which keeps this return from being pure alpha.

A positive alpha of 1.0 means the fund has outperformed its benchmark index by 1%. Correspondingly, a similar negative alpha would indicate an underperformance of 1%.

If a CAPM analysis estimates that a portfolio should earn 10% based on the risk of the portfolio but the portfolio actually earns 15%, the portfolio’s alpha would be 5%. This 5% is the excess return over what was predicted in the CAPM model.


Trading With Alpha

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