Wall Street Prep

Alpha (α)

Understand the Concept of Alpha

Learn Online Now

Alpha (α)

In This Article
  • What is the definition of alpha?
  • What is the standard benchmark to which alpha is compared?
  • How does alpha differ from beta?
  • What is the relationship between alpha and the efficient market hypothesis (EMH)?

Alpha Definition

Alpha refers to the incremental return achieved by fund managers in excess of benchmark returns.

If an investment strategy has generated alpha, the investor has “beat the market” with abnormal returns above that of the broader market.

Most often, the benchmark used to compare returns against is the S&P 500 market index.

Alpha Formula

In general, the formula for alpha can be explained as the difference between the return of an investment portfolio (e.g. stocks, bonds) and a benchmark return (e.g. S&P).

Alpha Formula

  • Alpha = Portfolio Return – Benchmark Return

Alternatively, the difference between the expected return from the capital asset pricing model (CAPM) – i.e. the cost of equity – and the portfolio returns is known as “Jensen’s Alpha”.

Alpha vs Beta in Investment Theory

Beta, in contrast to the concept of alpha, measures the risk/returns of the broader market, above which investors attempt to achieve returns.

In other words, beta is the minimum return for investors – or more specifically, the hurdle that “active” investors like hedge funds must exceed.

If not, investor capital would be better off being allocated to passive index investments (e.g. ETFs) that track the overall market performance.

Here, assuming the alpha is equal to zero, that would imply that the portfolio is tracking the broader market.

Active investment firms’ offerings should provide a benefit – either above-market returns or more stability (i.e. market hedge) – for their limited partners (LPs) to have an incentive to provide funding.

With that said, LPs of actively managed funds that prioritize high returns will gauge the investment acumen of a potential investment firm by tracking their historical alpha.

Alpha Formula and Investment Calculation Example

For instance, if an investment strategy has generated an alpha of 2%, that means the portfolio outperformed the market by 2%.

Conversely, a negative alpha of 2% means the portfolio underperformed the market by 2%.

Considering the fee structure – which is particularly high in the hedge fund industry (i.e. the “2 and 20” fee arrangement) – active investors must reasonably outperform the market or have consistent returns independent of the market.

In the latter, certain investment strategies seek not to outperform the market but to have sustainable low-risk returns, regardless of whether it is a bull or bear market.

Alpha in Investments vs. Efficient Market Hypothesis

For investors, alpha can stem from market efficiencies, irrational investor sentiment (i.e. herd-based mentality coupled with behavioral overreaction), or unexpected structural events (e.g. changes in rules and regulations).

The pursuit of alpha, generally speaking, tends to require a contrarian bet against the consensus and capitalizing on trends that most could not anticipate (i.e. “Black Swan” events).

The efficient market hypothesis (EMH) states that alpha, at least over the long run, cannot be reasonably and consistently produced since the market on average is correct – which makes active investing strategies obsolete across long time horizons.

However, generating alpha is easier said than done, as confirmed by the wave of hedge fund closures in recent years.

Globally Recognized Certification Program

Get the Equities Markets Certification (EMC©)

This self-paced certification program prepares trainees with the skills they need to succeed as an Equities Markets Trader on either the Buy Side or Sell Side.

Enroll Today
Comments
guest
0 Comments
Inline Feedbacks
View all comments
Learn Financial Modeling Online

Everything you need to master financial and valuation modeling: 3-Statement Modeling, DCF, Comps, M&A and LBO.

Learn More
X

The Wall Street Prep Quicklesson Series

7 Free Financial Modeling Lessons

Get instant access to video lessons taught by experienced investment bankers. Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts.