As explained in '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. (To understand beta, click here).
Given that alpha attempts to measure an active fund manager's worth versus a market benchmark, it may be tempting to single-mindedly pursue only the funds with the highest alphas and ignore the rest.
But this statistic has its limitations.
Alpha is dependent on the legitimacy of the fund's beta measurement. After all, it measures performance relative to beta. So, for example, if a fund's beta isn't meaningful because its R-squared is too low (below 75), its alpha isn't valid, either.
In other words, both alpha and beta are of limited use if a fund doesn't have a high correlation to the benchmark to which it's being compared. That's why it's important to check that a fund has a high R-squared with a benchmark before putting any weight on its alpha or beta. If a fund has a low correlation with its standard index, its corresponding alpha statistic is not reliable, nor is the beta statistic from which the alpha is derived.
All modern portfolio theory, or MPT, statistics are based on an investment's past return history; alpha, like beta, is a backward-looking measure and its predictive ability is far from guaranteed.
A fund's high alpha may owe to actual managerial talent, but it could also be the result of a series of lucky stock picks or sector bets. Is that high-alpha manager a genius, or did he just stumble upon a few hot stocks? If it was simply luck, that positive alpha figure could become negative as soon as the hot streak ends.
- Negative alpha is not always bad
Additionally, alpha fails to distinguish between underperformance caused by incompetence and underperformance caused by fees. For example, index funds have negative alphas which usually reflect the drag of expenses, even when expenses are very low.
An index fund may be perfectly correlated with its benchmark (as indicated by a R-squared of 100 and a beta of 1), but its alpha could be negative. This is because index fund managers don't engage in stock-picking and hence, are neither adding nor subtracting a significant amount of value. But many index funds will have negative alphas because fees eat into returns. Having said that, these funds can still be worthwhile core holdings.
Going by the above, it is worth noting that just as a high-alpha doesn't provide airtight evidence of a fund's merit, one must not be too quick to cross negative-alpha funds off your list.
