The world of finance and investments is notorious for its extensive use of jargon. With a goal to enhance financial literacy and make the world of money more transparent, we have our “monthly jargon” articles that focus on debunking financial terms that are often used sans explanation. This month, we’re discussing an investment term that is used as a measure of and indicator for investment performance: alpha.
What is Alpha?
The term “alpha” denotes an investment’s advantage on the market; in other words, the investment’s ability to beat and outperform the market. That being said, alpha is used as a performance measure to indicate when an investment has beat the market over a certain period of time. Alpha measures an investment’s performance versus a market index, like the S&P 500, or another benchmark that represents the market’s overall movement.
Alpha is known as a technical investment risk ratio that is used as a performance measure when evaluating individual stocks or funds. Traders and investors use risk ratios to assess their risk of loss to effectively manage their capital and investments. A risk ratio, like alpha, helps investors and traders calculate the expected return of a trade and the risk that comes with that potential trade. There are five main investment risk ratios, the other four being beta, R-squared, the Sharpe ratio, and standard deviation. Together with alpha, these five statistical measurements are routinely used in modern portfolio theory, a method for evaluating and picking investments to maximize overall returns amid a justifiable and sustainable level of risk. These risk ratios help risk-averse and risk-conscious investors construct diversified portfolios that aim to maximize returns, sans an exorbitant amount of risk.
Measuring and Evaluating Alpha
Alpha helps investors and traders evaluate the risk-return profile and potential outcome of an investment, and it is often used interchangeably with “excess return” because it identifies when investment returns are above the market benchmark being used for comparison. Alpha is typically used in conjunction with beta, as beta is a measure of the volatility or risk of an investment compared to the market as a whole. When evaluating an investment, the excess return of the investment relative to the return of the benchmark index is considered the investment’s alpha. That being said, alpha can be positive or negative – i.e., a potential investment may be seen as outperforming the market or underperforming the market.
Generating alpha is the goal of active portfolio management – which focuses on outperforming the market in comparison to a certain benchmark like the S&P 500 Index versus passive management, which involves mirroring the investment holdings of a particular index to achieve similar results – with an aim towards seeking excess returns with diversified investments that also aim to eliminate risk. In fund management, alpha denotes a portfolio’s performance in comparison to a benchmark index, and because of this, alpha represents the value a portfolio manager adds to or subtracts from a fund’s return relative to the fund’s benchmark.
By the Numbers
An alpha of zero means that the investment, portfolio, or fund being evaluated is performing on par with the benchmark index. Likewise, a negative alpha indicates performance below the benchmark index, and a positive alpha denotes performance above and superior to the benchmark index. Alpha is the return on an investment, portfolio, or fund that is not a result of positive movement in the market as a whole; alpha specifically represents the additional or negated value an investment brings with the broad market as the baseline.
Overall, alpha is used along with beta by investors and traders to calculate, compare, and analyze returns of investments, portfolios, and funds. When calculating and evaluating alpha, the baseline value is always zero, which represents the broad market. An alpha of one means the investment’s return during the timeframe being evaluated outperformed the overall market by 1%, a negative alpha denotes an investment that is underperforming compared to the market average, and an alpha of zero means the investment is matching the performance of the benchmark index.
Alpha is often used to rank the performance of mutual funds and many other investment vehicles to help active traders and investors outperform the market. Investors and traders who practice active investing often look for equities and funds with a high alpha in hopes of obtaining a greater return on investment (ROI) than if they were to practice passive investing, which involves investing in a fund that simply mirrors the holdings of a benchmark index to match the performance of the broad market.
Final Points
The alpha of an investment, portfolio, or fund is the excess return it produces compared to a benchmark index – it represents the degree to which an investment has either beat or lost to the market over a specific period of time. Alpha and beta are used together, along with several additional risk ratios, to evaluate an investment by measuring its return and volatility, respectively. Overall, alpha is a valuable tool when it comes to assessing investment performance and potential investment opportunities, and can help active investors and traders outperform the broad market.
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