Summary Intro

In the realm of investing, the term “Alpha” holds significant importance. It symbolizes an investment strategy’s ability to surpass the market, often referred to as its “edge.” Alpha is frequently used interchangeably with “excess return” or the “abnormal rate of return” when compared to a benchmark after adjusting for risk.

Alpha often goes hand in hand with “Beta,” represented by the Greek letter β. Beta measures the broader market’s volatility or risk, known as systematic market risk. While Beta reflects the overall market’s performance, Alpha stands as a testament to an investment strategy’s ability to outperform the market or a specific benchmark.

In the financial world, Alpha serves as a performance metric, indicating when a strategy, trader, or portfolio manager has successfully outperformed the market return or another benchmark over a given period. Alpha is often viewed as the “active return” on an investment and gauges its performance against a market index or benchmark that represents the market’s overall movement.

The excess return of an investment relative to the return of a benchmark index is what defines its Alpha. This excess return can be positive or negative and is the result of active investing. Unlike Alpha, passive index investing is the primary way to earn Beta.

What Is Alpha?

Alpha (α) is a term used in investing to describe an investment strategy’s ability to beat the market, or its “edge.” Alpha is thus also often referred to as excess return or the abnormal rate of return in relation to a benchmark, when adjusted for risk.

Alpha is often used in conjunction with beta (the Greek letter β), which measures the broad market’s overall volatility or risk, 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 or other benchmark over some period. Alpha, often considered the active return on an investment, gauges the performance of an investment against a market index or benchmark that is considered to represent the market’s movement as a whole.

The excess return of an investment relative to the return of a benchmark index is the investment’s alpha. Alpha may be positive or negative and is the result of active investing. Beta, on the other hand, can be earned through passive index investing.

Understanding Alpha

Alpha is among the five widely used technical investment risk ratios. The others include beta, standard deviation, R-squared, and the Sharpe ratio. These statistical measurements play a crucial role in modern portfolio theory (MPT). All these indicators aim to assist investors in determining the risk-return profile of an investment.

Active portfolio managers strive to generate alpha in diversified portfolios. Diversification serves to eliminate unsystematic risk. Since alpha represents the performance of a portfolio relative to a benchmark, it is often viewed as the value a portfolio manager adds to or subtracts from a fund’s return.

In simpler terms, alpha is the investment return that is not attributable to a general movement in the broader market. Therefore, an alpha of zero indicates that the portfolio or fund is perfectly aligned with the benchmark index, and the manager has neither added nor lost any additional value compared to the broad market.

Alpha in Investing

The concept of alpha gained prominence with the emergence of smart beta index funds associated with indexes like the Standard & Poor’s 500 index and the Wilshire 5000 Total Market Index. These funds aim to improve the performance of portfolios by tracking specific subsets of the market.

Despite the allure of alpha, many index benchmarks frequently outperform asset managers. This has led to a growing distrust in traditional financial advising, prompting investors to switch to low-cost, passive online advisors (robo-advisors). These advisors predominantly invest clients’ capital into index-tracking funds, acknowledging that joining the market may be more effective than attempting to beat it.

Furthermore, considering fees is crucial when evaluating portfolio performance and alpha. Traditional financial advisors typically charge fees, and when a portfolio nets an alpha of zero, it effectively represents a slight loss for the investor. For instance, if Jim, a financial advisor, charges 1% of a portfolio’s value and manages to produce an alpha of 0.75 during a 12-month period, Frank’s portfolio would still experience a net loss. This example highlights the importance of considering fees in conjunction with performance returns and alpha.

Efficient Market Hypothesis (EMH)

The Efficient Market Hypothesis (EMH) suggests that market prices promptly reflect all accessible information, leading to accurate security pricing. Consequently, the EMH posits that identifying and exploiting pricing discrepancies is impossible due to their non-existence.

Any mispricings are quickly corrected through arbitrage, making persistent market anomalies challenging to find.

Empirical evidence reveals that fewer than 10% of active mutual funds can consistently generate positive alpha over a decade, and this figure decreases when considering taxes and fees. Obtaining alpha is challenging, particularly after accounting for these expenses.

Some argue that alpha does not inherently exist. Instead, it compensates for taking unhedged risks that were previously unidentified or overlooked. By diversifying and hedging various risks, investors can isolate beta risk, which incurs transaction costs.

Understanding Investment Alpha

Alpha is a widely utilized metric for ranking active mutual funds and various investments. It’s commonly expressed as a single numerical value (e.g., +3.0 or -5.0) and generally represents the percentage difference between a portfolio’s or fund’s performance and that of a referenced benchmark index. For instance, a positive alpha of 3% indicates outperformance, while a negative alpha of 5% implies underperformance.

A more in-depth analysis of alpha may include Jensen’s alpha, which incorporates the capital asset pricing model (CAPM) market theory. Jensen’s alpha takes into account a risk-adjusted component in its calculation. Beta (or the beta coefficient) is utilized in CAPM to determine an asset’s expected return based on its specific beta and anticipated market returns. Investment managers leverage both alpha and beta to evaluate and contrast returns.

The investing landscape presents a diverse array of securities, investment products, and advisory options for investors. Additionally, distinct market cycles can influence the alpha of investments across asset classes. Therefore, considering risk-return metrics in conjunction with alpha is crucial for making informed investment decisions.

Example of Alpha

Alpha is illustrated in the following two historical examples of a fixed-income exchange-traded fund (ETF) and an equity ETF:

The iShares Convertible Bond ETF (ICVT) is a fixed-income investment with low risk. It tracks a customized index called the Bloomberg U.S. Convertible Cash Pay Bond > $250MM Index. The three-year standard deviation was 18.94% as of Feb. 28, 2022. The year-to-date return, as of Feb. 28, 2022, was -6.67%. The Bloomberg U.S. Convertible Cash Pay Bond > $250MM Index had a return of -13.17% over the same period. Therefore, the alpha for ICVT was 6.5% compared to the Bloomberg U.S. Aggregate Index and a three-year standard deviation of 18.97%.1

However, since the aggregate bond index is not the proper benchmark for ICVT (it should be the Bloomberg Convertible index), this alpha may not be as large as initially thought; in fact, it may be misattributed since convertible bonds have far riskier profiles than plain vanilla bonds.

The WisdomTree U.S. Quality Dividend Growth Fund (DGRW) is an equity investment with higher market risk that seeks to invest in dividend growth equities. Its holdings track a customized index called the WisdomTree U.S. Quality Dividend Growth Index. It had a three-year annualized standard deviation of 10.58%, higher than ICVT.2

As of Feb. 28, 2022, DGRW’s annualized return was 18.1%, which was also higher than the S&P 500 at 16.4%, so it had an alpha of 1.7% compared to the S&P 500. But again, 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 be inclusive of the 500 most valuable stocks in the United States.3

Alpha in Fixed-Income and Equity ETFs:

Alpha, a measure of excess return compared to a benchmark, can be observed in both fixed-income and equity exchange-traded funds (ETFs).

Fixed-Income ETF (iShares Convertible Bond ETF, ICVT):

• ICVT tracks the Bloomberg U.S. Convertible Cash Pay Bond > $250MM Index, representing a low-risk fixed-income investment.
• As of February 28, 2022, ICVT had a three-year standard deviation of 18.94% and a year-to-date return of -6.67%.
• Compared to the Bloomberg U.S. Aggregate Index, ICVT had an alpha of 6.5%.
• However, since convertible bonds have riskier profiles than plain vanilla bonds, the Bloomberg Convertible Index may be a more appropriate benchmark, potentially reducing the apparent alpha.

Equity ETF (WisdomTree U.S. Quality Dividend Growth Fund, DGRW):

• DGRW invests in dividend growth equities, representing a higher market risk equity investment.
• It tracks the WisdomTree U.S. Quality Dividend Growth Index, with a three-year annualized standard deviation of 10.58%, higher than ICVT.
• As of February 28, 2022, DGRW had an annualized return of 18.1%, higher than the S&P 500’s 16.4%, resulting in an alpha of 1.7% against the S&P 500.
• However, dividend-paying growth stocks may not be fully represented in the S&P 500, suggesting that a more tailored benchmark could affect the alpha calculation.

In both cases, the selection of an appropriate benchmark is critical for accurately assessing the alpha of an ETF. Factors such as risk profile and investment strategy should be considered when choosing a benchmark to ensure a meaningful comparison.

Considerations for Investors and Advisors

Alpha, often referred to as the “holy grail” of investing, draws significant attention from both investors and advisors. However, there are crucial considerations when utilizing alpha that should be taken into account.

A basic alpha calculation involves subtracting the total return of an investment from a comparable benchmark within its asset category. It is primarily used against a comparable asset category benchmark and does not measure the outperformance of an equity ETF against a fixed-income benchmark. This alpha is most effective when comparing the performance of similar asset investments.

Some references to alpha may refer to a more advanced technique known as Jensen’s alpha, which incorporates CAPM theory and risk-adjusted measures utilizing the risk-free rate and beta.

Understanding the calculations involved is crucial when using a generated alpha calculation. Alpha can be calculated using various index benchmarks within an asset class. In the absence of a suitable preexisting index, advisors may use algorithms and models to simulate an index for comparative alpha calculation purposes.

Additionally, alpha can refer to the abnormal rate of return on a security or portfolio exceeding the prediction of an equilibrium model like CAPM. In this instance, CAPM aims to estimate returns for investors at various points along an efficient frontier. If the portfolio earns 15% instead of the predicted 10%, its alpha would be +5% over the CAPM prediction.

FAQS

What Are Alpha and Beta in Finance?

In finance, alpha denotes the additional return achieved by an investment beyond a specified benchmark. In contrast, beta measures the investment’s volatility, commonly referred to as risk. Active investors aim to generate alpha returns through the implementation of distinct strategies.

What Is a Good Alpha in Finance?

In the realm of finance, particularly in trading and investing, the definition of a “good alpha” is influenced by the investor’s objective and risk tolerance. Essentially, a good alpha is one that exceeds zero while accounting for risk. The specific value of a good alpha may vary depending on these factors.

What Does a Negative Alpha Mean in Stocks?

A negative alpha in stocks means that a stock is underperforming the benchmark when adjusted for risk. If an investor is intending to match or outperform a specific benchmark and their investment portfolio is performing under that rate, then their alpha is negative.

Conclusion

The goal of an investor is to achieve the highest returns possible.

Alpha is a measure of performance regarding investment returns that are better when compared to a benchmark when adjusted for risk.

Active investors seek to achieve returns that are higher than a benchmark and can employ a variety of strategies to do so.

Many funds, such as hedge funds, have the purpose of achieving alpha and charge high management fees for doing so.