Understanding Alpha in Investing: Definition and Examples

What Is Alpha?

Alpha (α) is an investing term that measures an investment strategy's ability to outperform the market, often called its "edge." It represents the excess or abnormal return of an investment compared to a benchmark index, adjusted for risk.

A positive alpha indicates the investment beat the benchmark, while a negative alpha means it underperformed. Alpha is often discussed alongside beta (β), which measures the market's overall volatility or systematic risk. Together, they help investors assess both the performance and risk of active portfolio management. This article will build on these concepts with real-world examples and strategies to show how investors use alpha in practice.

Decoding Alpha: A Detailed Explanation

Alpha is one of five popular technical investment risk ratios. The others are beta, standard deviation, R-squared, and the Sharpe ratio. These are all statistical measurements used in modern portfolio theory (MPT). All of these indicators are intended to help investors determine the risk-return profile of an investment.

Portfolio managers aim for alpha by diversifying portfolios to reduce unsystematic risk. Because alpha represents the performance of a portfolio relative to a benchmark, it is often considered to represent the value that a portfolio manager adds to or subtracts from a fund’s return.

In other words, alpha is the return on an investment that is not a result of a general movement in the greater market. An alpha of zero means the portfolio tracks the benchmark perfectly, with no added or lost value.

Leveraging Alpha in Investment Strategies

Alpha gained popularity with smart beta index funds linked to indexes such as the S&P 500 and Wilshire 5000. These funds attempt to enhance the performance of a portfolio that tracks a targeted subset of the market.

Although alpha is desirable, most index benchmarks often outperform asset managers. Due to declining faith in traditional advising, many investors turn to low-cost online advisors, or robo-advisors, who invest in index-tracking funds because they prefer joining the market over trying to beat it.

Moreover, because most traditional financial advisors charge a fee, when one manages a portfolio and nets an alpha of zero, it actually represents a slight net loss for the investor. For example, suppose that Jim, a financial advisor, charges 1% of a portfolio’s value for his services and that during a 12-month period, Jim managed to produce an alpha of 0.75 for the portfolio of one of his clients, Frank.

While Jim has indeed helped the performance of Frank’s portfolio, the fee that Jim charges is in excess of the alpha he has generated, so Frank’s portfolio has experienced a net loss. For investors, the example highlights the importance of considering fees in conjunction with performance returns and alpha.

The Role of the Efficient Market Hypothesis in Alpha

The efficient market hypothesis (EMH) postulates that market prices incorporate all available information at all times, so securities are always properly priced (the market is efficient). According to the EMH, systematically exploiting market mispricings is impossible because they don't exist.

When mispricings are spotted, they are quickly corrected, making market anomalies rare.

Empirical evidence comparing historical returns of active mutual funds relative to their passive benchmarks indicates that fewer than 10% of all active funds are able to earn a positive alpha over a 10-plus-year time period, and this percentage falls once taxes and fees are taken into consideration. In other words, alpha is hard to come by, especially after taxes and fees.

Since beta risk can be managed by diversification and hedging, some argue that alpha is just compensation for unidentified risks.

How to Identify and Seek Investment Alpha

Alpha is commonly used to rank active mutual funds as well as all other types of investments. It is often represented as a single number (like +3.0 or -5.0) and typically refers to a percentage measuring how the portfolio or fund performed compared to the referenced benchmark index (i.e., 3% better or 5% worse).

A deeper analysis of alpha may also include Jensen’s alpha. Jensen’s alpha takes into consideration the capital asset pricing model (CAPM) market theory and includes a risk-adjusted component in its calculation. Beta (or the beta coefficient) is used in the CAPM, which calculates the expected return of an asset based on its own particular beta and the expected market returns. Alpha and beta are used together by investment managers to calculate, compare, and analyze returns.

The entire investing universe offers a broad range of securities, investment products, and advisory options for investors to consider. Different market cycles also have an influence on the alpha of investments across different asset classes. This is why risk-return metrics are important to consider in conjunction with alpha.

Real-World Examples of Alpha in Investing

Alpha is illustrated in the following two historical examples of a fixed-income exchange-traded fund (ETF) and an equity ETF:

The iShares Convertible Bond ETF (ICVT) is a fixed-income investment with low risk. It tracks a customized index called the Bloomberg U.S. Convertible Cash Pay Bond > $250MM Index. The three-year standard deviation was 18.94% as of Feb. 28, 2022. The year-to-date return, as of Feb. 28, 2022, was -6.67%. The Bloomberg U.S. Convertible Cash Pay Bond > $250MM Index had a return of -13.17% over the same period. Therefore, the alpha for ICVT was 6.5% compared to the Bloomberg U.S. Aggregate Index and a three-year standard deviation of 18.97%.

However, since the aggregate bond index is not the proper benchmark for ICVT (it should be the Bloomberg Convertible index), this alpha may not be as large as initially thought; in fact, it may be misattributed since convertible bonds have far riskier profiles than plain vanilla bonds.

The WisdomTree U.S. Quality Dividend Growth Fund (DGRW) is an equity investment with higher market risk that seeks to invest in dividend growth equities. Its holdings track a customized index called the WisdomTree U.S. Quality Dividend Growth Index. It had a three-year annualized standard deviation of 10.58%, higher than ICVT.

As of Feb. 28, 2022, DGRW’s annualized return was 18.1%, which was also higher than the S&P 500 at 16.4%, so it had an alpha of 1.7% compared to the S&P 500. But again, the S&P 500 may not be the correct benchmark for this ETF, since dividend-paying growth stocks are a very particular subset of the overall stock market, and may not even be inclusive of the 500 most valuable stocks in the United States.

Important Considerations When Evaluating Alpha

While alpha has been called the “holy grail” of investing, and as such receives a lot of attention from investors and advisors alike, there are a couple of important considerations that one should take into account when using alpha.

1. A basic calculation of alpha subtracts the total return of an investment from a comparable benchmark in its asset category. This alpha calculation is primarily only used against a comparable asset category benchmark, as noted in the examples above. Therefore, it does not measure the outperformance of an equity ETF vs. a fixed-income benchmark. This alpha is also best used when comparing the performance of similar asset investments. Thus, the alpha of the equity ETF, DGRW, is not relatively comparable to the alpha of the fixed-income ETF, ICVT.
2. Some references to alpha may refer to a more advanced technique. Jensen’s alpha takes into consideration CAPM theory and risk-adjusted measures by utilizing the risk-free rate and beta.

When using a generated alpha calculation, it is important to understand the calculations involved. Alpha is calculated using different index benchmarks within an asset class. If no suitable index exists, advisors use algorithms to simulate one for alpha comparisons.

Alpha can also refer to the abnormal rate of return on a security or portfolio in excess of what would be predicted by an equilibrium model like CAPM. In this instance, a CAPM might aim to estimate returns for investors at various points along an efficient frontier. The CAPM analysis might estimate that a portfolio should earn 10% based on the portfolio’s risk profile. If the portfolio actually earns 15%, the portfolio’s alpha would be 5.0, or +5% over what was predicted in the CAPM.

The Bottom Line

Alpha measures the excess return an investment earns above its benchmark after adjusting for risk, making it a key metric for evaluating performance. Active managers strive to generate alpha, often using strategies reflected in measures like Jensen's alpha, which applies the CAPM framework.

Consistently achieving alpha is difficult; studies show fewer than 10% of active funds outperform over long periods, especially after taxes and fees. These challenges, alongside the efficient market hypothesis, have driven some investors toward low-cost passive funds and robo-advisors. Investors should weigh fees carefully, as they can erode gains attributed to alpha.