What it means
Investors take risk in the hope of earning a return. Some of the return simply comes from being exposed to the market, which is why a fund holding lots of shares tends to rise when the market rises.
Alpha tries to isolate the part of the return that does not come from that exposure. To work out alpha, you first need an expected return for the investment's risk.
This comes from the capital asset pricing model, which says expected return equals the risk-free rate plus beta times the market's extra return. Beta measures how sensitive the investment is to market movements, where a beta of 1.2 means it tends to move 20% more than the market.
Alpha is then the actual return minus that expected return. The version just described is called Jensen's alpha.
If a fund returns 12% when its risk justified 11.4%, its alpha is 0.6 percentage points. Many people use alpha loosely to mean outperformance, but the careful definition matters.
A fund that beats the market by taking far more risk has not necessarily created alpha, because the extra return may simply compensate for the extra risk. Alpha also depends on choosing the right benchmark, and a poor benchmark gives a misleading answer.
Alpha is hard to sustain. Few managers deliver positive alpha consistently after fees, which is why low-cost index funds attract so much money.
Investors should look at alpha over long periods and after costs, not a single good year. Alpha has a close relative in the world of tracking error, which measures how far a fund's returns stray from its benchmark.
A manager with high alpha and low tracking error is rare and valuable, whereas a manager with high tracking error can look brilliant or terrible depending on the period. Ratios such as the Sharpe ratio sit alongside alpha to give a fuller view of reward for risk.
In practice
Real-world examples
Example 1
A pension fund compares two equity managers. Manager A beat the market by 4% but took on a beta of 1.5, giving an alpha near zero. Manager B beat it by 2% with a beta of 0.9, giving a clearly positive alpha. The pension fund keeps B and reduces its allocation to A.
Example 2
An investor reviews a hedge fund that charges high fees. Its alpha is 1.5% before fees but negative after fees. The investor moves the money to a cheaper fund and saves several thousand dollars a year in costs.
Example 3
A robo-adviser publishes the alpha of its portfolios against a global index. It states the period and the benchmark so that clients can interpret the result. The firm warns that past alpha does not guarantee future results, and clients are shown several time periods.
Think of it
Alpha is like a student's grade relative to their predicted score based on study time. If they score higher than expected, that extra is alpha.
Formula
Calculation
Alpha = Actual portfolio return - [Risk-free rate + Beta x (Market return - Risk-free rate)]
A fund of $1,000,000 earns a 12% return, so it makes $120,000. The risk-free rate is 3%, the market returns 10% and the fund's beta is 1.2. Expected return = 3% + 1.2 x (10% - 3%) = 3% + 1.2 x 7% = 3% + 8.4% = 11.4%. Alpha = 12% - 11.4% = 0.6%, which on $1,000,000 is $6,000 of return above what the fund's risk would normally justify.Case study
Seen in the real world
Northstar Capital is a fictional investment manager that, in this illustrative story, advertised that its flagship fund beat the stock market by 3% a year. A prospective client, a family office, asked for the fund's alpha rather than its raw outperformance.
The analyst found that the fund had a beta of 1.4 and that the market's extra return over the risk-free rate averaged 6%. The expected extra return was therefore 1.4 x 6% = 8.4%, while the fund's extra return was 9% (6% market extra plus 3% outperformance), leaving an alpha of only 0.6%.
After accounting for a 1% management fee, the alpha was negative. The family office decided to invest in a low-cost index fund and keep the savings.
Watch out
Common mistakes
- Using alpha as another word for beating the market. Beating the market with higher risk is not the same as skill.
- Ignoring fees. A positive alpha before fees can disappear once costs are deducted.
- Judging a manager on a short period. Luck can dominate over one or two years.
Questions
People also ask
What is a good alpha?
Any consistently positive alpha after fees is good, but it is rare. Even a small figure like 1% a year, if sustained, is significant.
How does alpha differ from beta?
Beta measures sensitivity to the market, while alpha measures return beyond what that sensitivity explains. Beta is risk, and alpha is skill or luck. A fund can have a high beta and no alpha at all.
Can alpha be negative?
Yes. Many funds have negative alpha after fees, meaning investors would have done better in a simple index fund with the same risk.
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