Being able to generate alpha is touted as the holy grail of investing. But what exactly does alpha tell you and how is it calculated?
What is alpha?
Alpha is the difference between a fund's expected returns based on its beta and its actual returns. Alpha is sometimes interpreted as the value that a portfolio manager adds, above and beyond a relevant index's risk/reward profile. If a fund returns more than what you'd expect given its beta, it has a positive alpha. If a fund returns less than its beta predicts, it has a negative alpha.
Beta measures an investment's volatility, or more specifically, its sensitivity to the movements of a market index. On days when a market index generates a positive return, a fund with a high beta would be expected to gain even more than the index. On the flip side, the high-beta fund would be expected to lose more than the index during market downdrafts.
Alpha attempts to show whether a fund has adequately compensated investors for its volatility level, as reflected by its beta. For example, a high-beta fund might have experienced extreme performance gyrations relative to its benchmark. But if its returns have been even higher than its beta would predict, the fund has generated positive alpha. A low-beta fund can also generate positive alpha by generating higher returns than its beta would suggest.
To understand how beta works, click here.
How is alpha arrived at?
The starting point for calculating alpha is to find how much a fund and its benchmark have returned (on a monthly basis) over the return of a guaranteed risk-free investment such as a Treasury Bill. You then find the expected return for the investment by multiplying the fund's beta by the benchmark's excess returns. The difference between the fund's actual return and its expected return is its alpha. If alpha is positive, it means that the fund returned more than its expected return, whereas a negative alpha indicates that the fund returned less.
For example, let's say an equity fund generated an excess return of 10% in a given time frame and the Nifty generated an excess return of 8%. If the fund had a beta of 0.5, its expected return would be just 4%. (0.5 x 8%). But given the fund's actual excess return of 10%, the fund's alpha is 6% (10% - 4%).
Bear in mind that a higher beta (higher risk relative to an index) does not necessarily equate to higher alpha (greater return for that risk); a high-beta fund may well sport a negative alpha. That's because the greater the risk the fund assumes, the higher the hurdle the fund must jump over in order to outperform the benchmark. Moreover, because alpha is determined by both a fund's return and risk, two funds could have the same returns but their differing risk levels will lead to two distinct alphas.
