Often, alpha is used to compare mutual funds against their expected return or to describe an investment manager’s performance. Positive alpha means better performance than the market, while negative alpha means worse performance. Find out how alpha works and why it’s important for investors to understand.
Definition and Examples of Alpha
Alpha describes the success of an investment strategy versus a similar benchmark. In other words, alpha shows how much an investment overperforms or underperforms its expected returns. Alpha is closely related to beta, a measure of how volatile an investment is compared with a benchmark. The beta of the market as a whole is 1. A beta greater than 1 indicates a fund that is more volatile than the market. Betas under one indicate funds less volatile than the market. It is calculated by comparing the excess returns of the market and the fund in question with the risk-free return rate. For example, if an exchange-traded fund (ETF) has a beta of 1.2, you’d expect it to move 20% more than the benchmark. If the benchmark S&P 500 gains 5%, you’d expect an ETF with a beta of 1.2 to gain 6% (5% * 1.2 = 6%). Alpha measures the actual return of an investment compared with the return that investors expect based on its beta. Alpha is sometimes thought of as the value that a portfolio manager adds, above and beyond a relevant index’s risk/reward profile. Using the above example, if the ETF instead gained 7%, it would have a positive alpha. If it gained only 5%, it would have a negative alpha.
How Does Alpha Work?
Alpha works by measuring the over- or underperformance of an investment, typically an ETF or a mutual fund, against its expected return as determined by its beta. Recall that a fund’s beta describes the expected return of the fund based on changes in the fund’s benchmark. If a fund with a beta of 1.3 is benchmarked to the S&P 500, a 10% loss in the S&P is expected to result in a loss of 13% for the fund. You can use this formula to calculate a fund’s alpha for a given time period: Return - risk-free return rate - (benchmark return * beta) = alpha Typically, the risk-free rate of return is the return of 90-day Treasury bills or some other highly safe government bond. Using the above example, imagine the fund lost 10% instead of the expected 13% and that the risk-free rate is 0%. The fund’s alpha would be: -10% - 0% - (-10% * 1.3) = -10% - (-13%) = 3 The fund performed better than expected, meaning it has a positive alpha. If it instead lost 15%, it would have a negative alpha of: -15% - 0% - (-10% * 1.3) = -15% - (-13%) = -2 The negative alpha indicates that the fund lost more than it was expected to, based on its beta and the benchmark’s return.
What It Means for Individual Investors
Alpha is one of the major measures of investment risk that individual investors should look for. Positive alphas indicate that a fund has performed better than expected in the past while negative alphas show funds that underperform. While past results don’t guarantee future returns, a mutual fund that has consistently negative alphas might be risky. Those with consistently positive alphas could help you grow the value of your portfolio more quickly.
