Alpha is also commonly known as an excess return or abnormal rate of return which is used alongside beta, which is the measure of the volatility of the market. Alpha is often for the diversified portfolio, which removes the unsystematic risk. It is a measure of the portfolio’s results in conjunction with a benchmark. Hence it is also a measure of value that sees an introduction or decrease from the return by the portfolio manager.
What is Alpha?
Alpha or α is a term popular in the investing world. It usually denotes the efficacy of an investment strategy to be ahead of the market or on the “edge” of the market. Alpha is also commonly a referral for an excess return or abnormal rate of return. It acts alongside beta, which is the measure of the volatility of the market. This is also the systematic market risk.
There are 5 prominent technical terms for technical investment risk ratios. Alpha is one of them. All these 5 terms will occur simultaneously in Modern Portfolio Theory (MPT). This helps the investors to assess the return and risk factors of any investment profile.
Diversified portfolio
With active portfolio management, alpha is often for the diversified portfolio, which removes the unsystematic risk. Alpha is the measure of the portfolio’s results in conjunction with a benchmark. Hence it is also a measure of value that is introduced or decreased from the return by the portfolio manager.
Therefore, an Alpha denotes returns on any investment not created as a result of the direction of the market. Hence, if the Alpha for your investment is 0, then it means the funds are in alignment with the benchmark. Also, no value comes in or decreases by the manager.
Alpha in investing
Even when an alpha results in a zero, you will pay a fee to the traditional manager. This actually signifies a loss for the investor. According to EHM (Efficient Marketing Hypothesis) assumptions, the market prices include all the data and information that is present. The prices of the securities are always ready in determination. Hence, there is little to no window to take advantage of the difference in prices because there is none.
In case any difference in prices is found, arbitrage takes place. They quickly fall back to regular pricing. The advantage-taking anomalies reduce to very few. Information about the comparison to historical data on the returns on mutual funds in comparison to passive benchmarks shows that less than 10% of active funds get an alpha that is beneficial in an average period of over 10 years. Moreover, this percentage decreases as taxes and fees are taken into account. In conclusion, Alpha is difficult to inculcate when there are hefty fees and taxes.
Alpha and Beta
Since the risk of beta is under control by hedging and diversifying, there are assumptions that Alpha is not real. However, it is the compensation representation for taking on the un-hedged risk that is overlooked previously. This concept gains more prominence with the onset of smart beta funds linked with the indexes including the Standard & Poor’s 500 index and the Wilshire 5000 Total Market Index. These funds have the goal to accelerate the performance of the investor’s funds. This can be negative and positive or zero which is also due to active investing.
