The amount of return expected from an investment from its inherent value. The term alpha describes the ability of an investment strategy to outperform the market, or its "edge". As a result, alpha is also frequently referred to as "excess return" or "abnormal rate of return," which relates to the notion that because markets are efficient, it is impossible to consistently generate returns that are higher than those of the general market. The Greek letter beta, which represents the total volatility or risk of the broad market (sometimes referred to as systematic market risk), is frequently employed in conjunction with alpha. Alpha, delta, as well as gamma, vega, and theta, are terms commonly used by options traders to describe the risk and reward of their respective option positions. These terms are often referred as the "Greeks," and characterize the degree to which the value of an option fluctuates in response to changes in observable parameters.
Alpha Explained
Alpha is one of the five most widely used technical risk ratios for investing (the The other four are the Sharpe ratio, the R-squared, the standard deviation, and beta). All of these metrics are employed in contemporary portfolio theory (MPT) and are geared toward assisting investors in evaluating an asset's potential risks and rewards.
Diversification is used by active portfolio managers to reduce the likelihood of losses due to systematic risk. In the context of investing, alpha is commonly understood to indicate the value added or subtracted by a portfolio manager to the return of a fund relative to a benchmark.
To rephrase, alpha refers to the portion of an investment's return that is not attributable to fluctuations in the market as a whole. Therefore, if the alpha of a portfolio or fund is zero, it means that the investment results from the managed asset are identical to those of the benchmark index, and that there has been neither gained nor lost value relative to the market.
With the rise of smart beta index funds that track prominent benchmarks like the S&P 500 Index, the concept of alpha has gained traction. These investments aim to improve the efficiency of a portfolio that follows a specific segment of the market.
Despite the fact that alpha is highly desirable, many index benchmarks nonetheless end up outperforming asset managers. Investors are increasingly turning away from traditional financial advice in favor of low-cost, passive online advisers (commonly termed robo-advisors) that invest customers' wealth completely or almost exclusively into index-tracking funds. This shift is motivated in part by the belief that investors have little chance of outperforming the market on their own.
Even if a portfolio manager achieves an alpha of zero, the investor still incurs a tiny loss because most "conventional" financial advisors charge a fee.
Fewer than 10% of active mutual funds may produce a positive alpha over a 10-year period, and this figure reduces when taxes and fees are considered. To rephrase, finding alpha is difficult, especially after accounting for costs.
Since beta risk may be separated via diversification and hedging, it has been argued that alpha does not exist and is instead the result of being compensated for taking a previously unknown or unaccounted-for risk.
Take Alpha Into Account
Although many investors and financial counselors focus on alpha as though it were the "holy grail" of investing, it's crucial to keep in mind a few things before putting it to use.
Simple alpha is determined by deducting the investment's entire return from the benchmark's total return in the same asset class. As was mentioned above, this alpha calculation is often only applied when compared to a benchmark for a similar asset type. As a result, it is not a reliable indicator of whether or not an equity ETF has outperformed a fixed-income benchmark.
A more sophisticated method may be meant when the word "alpha" is used. Through the use of the risk-free rate and beta, Jensen's alpha accounts for Capital Asset Pricing Model (CAPM) theory and risk-adjusted metrics.
It is crucial to comprehend the computations behind a created alpha before employing it. Different index benchmarks within the same asset class might be used to determine alpha. If no appropriate index already exists, advisors can create their own using algorithms and other models to utilize in calculating relative alpha.
In finance, a security's or a portfolio's alpha can also measure the abnormal rate of return if it is higher than the rate of return expected by an equilibrium model such as the capital asset pricing model (CAPM). Estimating returns for investors at different places along an efficient frontier could be one goal of a CAPM model in this setting.
The CAPM might conclude that a 10% return is appropriate for a given portfolio given its risk level. For example, if the portfolio's alpha is 8% over the CAPM forecast, it means that the portfolio has achieve an actual return of 18%.