Key Takeaways
- Alpha (α), used in finance as a measure of performance, is the excess return of an investment relative to the return of a benchmark index.
- Alpha is usually paired with beta (β), which measures an investment’s volatility or systematic risk compared to the overall market.
- Generating alpha is the goal of many investors seeking higher returns than the market average.
In investing, alpha (α) measures the return on investment that exceeds the expected return based on the risk associated with a particular investment strategy. It measures an investment’s ability to outperform the market or achieve higher returns than the market average.
To clarify things for those in search of alpha and how investment portfolios are built: alpha is often referred to as “excess return” or “abnormal rate of return.” This concept assumes that markets are efficient, meaning that all available information is already reflected in an asset’s price.
Alpha is usually paired with beta (β), which measures an investment’s volatility or systematic risk compared to the overall market.
Generating alpha is the goal of many investors seeking higher returns than the market average. To do this, investors use various investment strategies, such as analyzing financial statements, tracking market trends, and identifying undervalued assets.
What is Generating Alpha?
An alpha generator refers to a security that offers excess returns or higher than the pre-selected benchmark without additional risk when added to an existing portfolio of assets. Financial institutions, including banks, hedge funds, and quantitative traders, often leverage algorithmic trading technology to identify alpha generators that enable them to outperform or beat the market consistently. In other words, an alpha generator is a tool that helps investors generate superior returns without incurring additional risk.
Alpha generators can be various securities: government bonds, foreign stocks, derivatives such as stock options and futures, and other investment categories related to alpha generation finance.
To understand the concept of alpha, it is essential first to comprehend the fundamentals of the modern portfolio theory (MPT).
Modern Portfolio Theory
Alpha is among five widely used technical risk ratios for investments. The remaining four are beta, Sharpe ratio, standard deviation, and R-squared. These are statistical measurements that belong to modern portfolio theory (MPT). These ratios assist investors in evaluating the risk-return nature of an investment.
Portfolio managers actively managing their portfolios aim to generate alpha by investing in various assets. This diversification strategy is intended to reduce the impact of unsystematic risks on the portfolio. Alpha represents the portfolio’s performance relative to a benchmark, and it is often seen as the measure of the portfolio manager’s value added or subtracted from the fund’s return.
For simplicity, generating alpha refers to earning profits from an investment not influenced by the overall market trends. An alpha of zero would suggest that the fund or portfolio performs as well as the benchmark index without any additional gains or losses compared to the overall market performance.
The idea of alpha gained more prominence when smart beta index funds linked to well-known indexes, such as the Standard & Poor’s 500 index and the Wilshire 5000 Total Market Index, emerged. These funds aim to improve the performance of a portfolio that follows a particular part of the market.
Although alpha is an attractive feature in any investment portfolio, most asset managers are outperformed by index benchmarks. As a result of this trend, many investors are losing confidence in traditional financial advisors and turning to low-cost, passive robo-advisors (Online advisors).
These online advisors invest client capital almost entirely in index-tracking funds on the premise that if they can’t beat the market, they should just join it.
Alpha Coefficient
With an understanding of MPT, the focus can shift to alpha (αi). MPT includes five distinct risk ratios, which help investors assess the risk-return profile of an investment. These ratios have alpha, beta, R-squared standard deviation, and Sharpe ratio.
In simple terms, alpha is used to measure investment performance in relation to risk. As an investor, we need to ensure that we are adequately rewarded for the risks associated with our investments, and alpha can assist us in determining whether an investment is worthwhile. Alpha is expressed as a numeric value.
If an investment has a positive alpha of 1.0, it has done better than its benchmark index by 1%. On the other hand, if it has a negative alpha of the same value, it indicates that it has underperformed by 1%. Finally, zero alpha suggests the investment has achieved the same risk-adjusted return as its benchmark.
To make it more precise, the alpha coefficient measures an investment’s performance in relation to its risk.
The following are the interpretations:
- If αi is less than zero, the investment did not earn enough to justify the risk taken, or it was excessively risky for the return obtained.
- If αi equals zero, it indicates that the investment earned a return commensurate with the risk taken.
- If αi is greater than zero, it implies that the investment generated a return that exceeded the level of risk undertaken.
Investors can leverage modern portfolio theory (MPT) and its risk statistics, including alpha, to evaluate whether the expected return of alpha investments justifies the level of risk involved. This approach enables them to gauge whether a particular investment is worth considering or not.
Investment managers often state that their objective is to generate alpha, meaning they aim to achieve higher returns while taking on a comparable level of risk as the benchmark they use to measure their performance. Alpha represents the extra value that an asset or portfolio manager brings compared to a related index’s risk and reward profile. Naturally, a higher alpha is considered beneficial.
