Alpha (Finance)

What is “Alpha”?

Alpha is the difference between the return of a portfolio and a benchmark return. The benchmark can be various things, such as the returns of a stock market index (for example, the S&P 500 or Russell 1000) or the CAPM expected return. The capital asset pricing model (CAPM) return measures the expected return on an asset based on its risk. The difference between the CAPM expected return and the portfolio return is known as Jensen’s alpha.

Irrespective of the benchmark used, alpha measures how much return is attributed to the portfolio manager’s investment decisions. Investors in actively managed investment funds want as high an alpha as possible since this indicates superior returns compared to the benchmark. The symbol used to depict alpha is ‘α’, the Greek letter alpha.

One reason alpha is created is that markets are not always efficient. Market inefficiencies could stem from either behavioral forces or structural forces. Behavioral inefficiencies can be caused by irrational decisions of some market participants.  or rules and regulations, such as government restrictions on foreign capital inflows in certain sectors, can lead to structural inefficiencies. Correctly spotting such inefficiencies can allow a portfolio manager to generate higher returns than the benchmark.

Alpha Explained

Alpha is one of the measures used in attribution analysis, a tool used by investors to measure the impact of a portfolio manager’s decisions on the overall portfolio performance. In its simplest form, alpha is measured as follows:

Alpha = Portfolio’s absolute return – Benchmark return

If alpha is greater than 0, it means the portfolio manager has outperformed the benchmark. If alpha is less than 0, the portfolio manager has underperformed the benchmark.

Jensen’s alpha is a variant of alpha that measures the risk-adjusted performance of a portfolio.  Also known as “ex-post alpha”, Jensen’s alpha measures the difference between the actual portfolio return and the required return from CAPM. Based on the CAPM equation,

 Creating or Destroying Alpha

Investors or portfolio managers can create alpha by going overweight on undervalued securities and underweight on overvalued securities. Here is one example of a portfolio manager creating alpha. Both the benchmark and the portfolio have a similar weighting to tech stocks.

The benchmark index comprises 30% of tech stocks. The portfolio manager has adopted a similar strategy of investing 30% of the portfolio’s funds in tech stocks. So, the performance of the portfolio will not be influenced by the amount allocated to this sector. However, the portfolio manager is trying to beat the benchmark and create alpha by going overweight (assigning a higher weight) on security A and underweight on security B.

If this security A is a relatively better performing stock, alpha is created. However, if security B outperforms the other tech stocks in the benchmark, alpha is destroyed as the portfolio manager has not invested in this stock while it is included in the benchmark. Portfolio managers can also shift exposures opportunistically to attractive markets or factors seeking excess return, referred to as market timing.

Example

The table below includes the returns for the securities in the portfolio discussed previously. We will use this information to determine whether an investor has created alpha and describe how it was created or destroyed:

Security 1 has a return of 10%, security 2 of 5%, and security 3 of 0%.

In this example, alpha was created through security selection. There was no market timing since the benchmark weight, and portfolio weights are equal.

Since the portfolio manager was overweight in security 1, and security A outperformed relative to the other securities, alpha was created. If the additional 10% weight added to security A in the portfolio had been allocated to either of the other securities, the portfolio’s return would have been lower.

Despite the portfolio being underweight in security B, this has not created or destroyed alpha, since this security’s performance matches the performance of the benchmark as a whole.

For security C, the weighting of the portfolio matched the weighting in the benchmark, so despite this security performing worse than the other securities in the benchmark, security C had no effect on alpha.

Creation/Destroying of Alpha based on Portfolio Weight and Security Performance

Here is a summary of how alpha is created or destroyed based on the portfolio manager being overweight or underweight and on the securities’ performance in the benchmark.

If a portfolio manager is overweight on a security, and it underperforms, alpha is destroyed. If it outperforms, alpha is created.

If the manager is underweight on a security and it underperforms, alpha is created, since less money was invested in a poorly performing security. However, if it outperforms, alpha is destroyed, since the portfolio has missed out on the good performance of that security.

Alpha vs Beta

We look at the relationship between alpha and beta in two ways:

1. Portfolio management
2. The CAPM model

Portfolio Management

From the perspective of portfolio management, the beta return is the benchmark return. If the benchmark has returned 100 and the portfolio has returned 120, alpha is created. If the portfolio returns 80, alpha is destroyed.

The CAPM Model

In the CAPM model, beta is a theoretical measure of systematic risk in a security or a portfolio as compared to the market or the benchmark as a whole. The beta of the market or the benchmark must be 1 since this is measuring the market’s volatility relative to itself.

If the beta of a security or portfolio is higher than 1, it indicates higher systematic risk than the market. If the beta is lower than 1, it indicates lower systematic risk than the market. Companies with greater predictability in their earnings and dividends tend to have lower beta values.

The table below explains the relationship between beta and alpha based on market scenarios. An up market scenario is when the benchmark is giving positive returns. A down market scenario is when the benchmark is giving negative returns

Additional Resources

Passive (Index) Investing
Performance Attribution
Portfolio Management Course
Portfolio Construction