What is alpha?
Alpha is the excess return on an investment when compared with an equivalent security. For example, when evaluating a mutual fund, an alpha of 2, a = 2, means the mutual fund outperformed the benchmark investment by 2 percent. If the mutual fund’s alpha is a = -1.5, this means the mutual fund underperformed the benchmark by 1.5 percent.
In financial markets where mutual funds are widely available, alpha is frequently used to evaluate the performance of these funds and similar investments. Funds with higher fees must maintain higher alpha to generate higher gains to offset those fees.
Alpha is one of five technical risk ratios used to compare the expected returns of an investment with the amount of risk taken. The other risk ratios are beta, R-squared, standard deviation and Sharpe ratio. All of these risk ratios are designed to help investors evaluate risk and help investors determine the risk-to-reward ratio of a fund.
As index funds like the S&P 500 became available, the concept of alpha developed as a way for investors to compare portfolio managers’ performance against a benchmark. If the portfolio produced a positive alpha return, this demonstrated that the portfolio manager was exceeding the benchmark performance expectations. If the portfolio delivered a negative alpha, the portfolio manager underperformed the benchmark performance expectations.
When comparing funds and evaluating for alpha, costs must be taken into consideration. Investing in a mutual fund that has an alpha of 1.0 but charges 1.7 percent in fees may not result in a higher return than an index fund that charges 0.5 percent in fees.
Alpha is used to compare a wide variety of investments, but is useful only when comparing two investments in the same asset class. For example, comparing a large-cap stock fund with an emerging-market stock fund would not provide a meaningful comparison. In order for alpha to be valuable, it must be calculated relative to an appropriate benchmark. However, comparing two mid-cap domestic stock funds may provide a meaningful comparison and allow the investor to accurately measure the performance of both funds.
Example of alpha
Alpha is most often used with beta to evaluate the risks and performance of mutual funds. Beta measures the risk or volatility of an investment compared with the market as a whole. Both alpha and beta are considered backward-looking risk ratios, meaning they evaluate future performance by analyzing historical measures. Both alpha and beta measure benchmark indexes to predict performance and returns.