What is alpha in investing? What does alpha mean?

What is Alpha?

In finance, Alpha (α) or Jensen's alpha is a measure of the excess return of an investment relative to the expected return of a portfolio as determined by the capital asset pricing model (CAPM). In other words, it represents the part of the investment's return that is not due to the general movement of the market but rather is a result of the specific characteristics of the investment itself.

How to calculate Alpha?

Mathematically, Alpha can be calculated as the excess return as follows:

α = Actual Portfolio Return - Expected Portfolio Return
α = R_p - ( R_f + Beta * (R_m - R_f))

where R_p = the portfolio return, R_f = risk-free rate, R_m = the benchmark or market return, Beta is the measure of a stock's volatility relative to the overall market.

Example of how to calculate Alpha

For example, if a portfolio generates a return of 25% over a certain period of time with risk free rate = 2% , portfolio beta = 1.2, and the benchmark index returns 20% over the same period, then the alpha of the investment would be:

α = 25% - (2% + 1.2 * (20%-2%)) = 25% - 23.6% = 1.4%

The interpretation is as follows; given the portfolio beta = 1.2 which is slightly riskier than the market/benchmark, we expect a higher return as calculated by CAPM model which in this case is equal to 23.6%. The actual return is 25% which is 1.4% above that expectation and that is what Alpha is.

Alpha is often used as a measure of the skill or active management of a fund manager.

Positive Alpha

A positive alpha means that the investment manager's active management has a positive impact on portfolio return compared to the benchmark at the same risk level (return volatility).

Negative Alpha

A negative alpha, on the other hand, means that the manager has underperformed the benchmark at the same risk level.

Alpha vs Beta, what is the difference?

Alpha and beta are different measurements that capture different aspects of investments and investment strategies. Alpha refers to the performance of an investment relative to the expected return as calculated by CAPM. A positive alpha indicates that the investment has outperformed the expected return, while a negative alpha means it has underperformed. Beta, on the other hand, is part of CAPM which measures the volatility of an investment relative to the overall market. A beta of 1 means the investment is as volatile as the market, while a beta greater than 1 indicates higher volatility and a beta less than 1 indicates lower volatility. You can read more about Beta on the "What is beta?" article.

What is alpha investing?

Alpha investing is a term used to describe a strategy for selecting stocks or other investments that are expected to outperform the market as a whole. This type of investing is often associated with active management, in which a fund manager or individual investor actively selects and trades securities in an effort to achieve superior returns.

Alpha investing involves trying to identify investments that are likely to generate positive alpha. This can be done through a variety of methods, including fundamental analysis, technical analysis, and even using data analytics to identify patterns and trends in financial markets.

One of the main goals of alpha investing is to generate returns that are not correlated with the market as a whole. This can be attractive to investors who are looking for a way to diversify their portfolio and potentially reduce risk.

It's important to note that alpha investing is not without risk. While the goal is to generate positive alpha, there is no guarantee that an investment will outperform the benchmark index. In addition, alpha investing requires a higher level of active management and a deeper understanding of financial markets, which may not be suitable for all investors.

Overall, alpha investing is a strategy that seeks to identify investments that are expected to outperform the market and generate excess returns. While it can be a potentially rewarding approach for experienced investors, it also carries a certain level of risk and may not be suitable for everyone.