what is alpha 
alpha is a term used in investing to describe an investment strategy s ability to beat the market or its edge alpha is thus also often referred to as excess return or the abnormal rate of return in relation to a benchmark when adjusted for risk alpha is often used in conjunction with beta the greek letter which measures the broad market s overall volatility or risk known as systematic market risk alpha is used in finance as a measure of performance indicating when a strategy trader or portfolio manager has managed to beat the market return or other benchmark over some period alpha often considered the active return on an investment gauges the performance of an investment against a market index or benchmark that is considered to represent the market s movement as a whole the excess return of an investment relative to the return of a benchmark index is the investment s alpha alpha may be positive or negative and is the result of active investing beta on the other hand can be earned through passive index investing sydney saporito investopediaunderstanding alphaalpha 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 active portfolio managers seek to generate alpha in diversified portfolios with diversification intended to eliminate 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 as such an alpha of zero would indicate that the portfolio or fund is tracking perfectly with the benchmark index and that the manager has not added or lost any additional value compared to the broad market applying alpha to investingthe concept of alpha became more popular with the advent of smart beta index funds tied to indexes like the standard poor s 500 index and the wilshire 5000 total market index these funds attempt to enhance the performance of a portfolio that tracks a targeted subset of the market despite the considerable desirability of alpha in a portfolio many index benchmarks manage to beat asset managers the vast majority of the time due in part to a growing lack of faith in traditional financial advising brought about by this trend more and more investors are switching to low cost passive online advisors often called robo advisors who exclusively or almost exclusively invest clients capital into index tracking funds the rationale being that if they cannot beat the market they may as well join 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 efficient market hypothesisthe 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 therefore according to the emh there is no way to systematically identify and take advantage of mispricings in the market because they do not exist if mispricings are identified they are quickly arbitraged away so persistent patterns of market anomalies that can be taken advantage of tend to be few and far between 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 because beta risk can be isolated by diversifying and hedging various risks which comes with various transaction costs some have proposed that alpha does not really exist but simply represents the compensation for taking some unhedged risk that hadn t been identified or was overlooked seeking investment alphaalpha 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 example of alphaalpha 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 1however 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 2as 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 3alpha considerationswhile 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 