Alpha definition

What is alpha in finance?

Alpha is the measurement of an investment portfolio’s performance against a certain benchmark –usually a stock market index. In other words, it’s the degree to which a trader has managed to ‘beat’ the market over a period of time. The alpha can be positive or negative, depending on its proximity to the market.

Alpha is not only used as a measure of the portfolio compared to the underlying market, but also of the performance of the fund manager – who implements the strategies and manages trading activity.

Alpha vs beta

Alpha and beta are used in conjunction to compare and analyse portfolio returns. While alpha is the measure of the return of a portfolio, beta is the measure of its past volatility – or risk – when compared to the wider market. For example, if the beta figure is 1.2, it means the stock is 20% more volatile than the market.

Example of alpha in finance

The basic calculation of alpha simply subtracts the total return of an investment from the benchmark returns, over the same period.

However, it is common to use the capital assets pricing model, or CAPM for short, to gain a more detailed insight into a portfolio’s performance. With this calculation, you subtract the risk-free rate of return (ROR) from the expected return, and then subtract the beta to get to the risk premium. You would then multiply this premium by the market (benchmark) return minus the risk-free rate of return. The calculation looks like this:

Alpha = portfolio return – risk-free ROR – beta * (benchmark return – risk-free ROR)

Let’s say that the expected return is 12% after a year, the risk-free rate of return is 10%, the beta is 1.2 and the benchmark is 11%. Your alpha calculation would then be: 12 – 10 – 1.2 x (11 – 10).

This means that the alpha is 0.8%. This positive percentage means the portfolio is outperforming the market. It is worth noting that the alpha of a portfolio is subject to change if the positions become subjected to larger amounts of volatility – causing the beta to change.

Pros and cons of alpha

Pros of alpha

Alpha can give fund managers a general idea of how their portfolios are performing against the rest of the market. In trading and investing, alpha can be helpful tool for establishing market entry and exit points.

Cons of alpha

Using alpha as a method to calculate returns has its limitations – it cannot be used to compare different investment portfolios or asset types, as it is restricted to stock market investments.

There is a lot of debate about the accuracy of alpha as a measurement. According to the efficient market hypothesis (EMH), all securities are properly priced at all times, so it would be impossible to identify and take advantage of mispricing. If EMH is true, there would be no way to ‘beat’ the market, and alpha would not exist.

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