Archimedes Finance

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Expecting the unexpected

Lesson in Course: Portfolio management (advanced, 6min )

I've heard some investors talk about alpha, but what is it?

Alpha is one way for us to measure performance as investors. When we make an investment decision, we have some idea of what we expect to receive as a return on that investment over a given period of time. There are many ways we can come up with the expected return and the actual return over that time is usually different. The difference between the expected return and the actual is where alpha comes in.

Alpha measures the excess return on a risk-adjusted basis. This is the performance that we weren’t expecting to get relative to the risks that we took. In practice, alpha is the outperformance or underperformance relative to some benchmark or index. An investment has a positive alpha if it has a higher return than its benchmark and a negative alpha if the return is lower than the benchmark.

We can use the following formula to get started:

Alpha = Return of investment - Return of benchmark

 

Alpha of a mutual fund

Alpha can be used to evaluate the performance of a mutual fund relative to a benchmark index. For a fund that invests broadly in US stocks, their alpha might be based on comparing it’s return to the S&P 500. 

Alpha is often used to justify higher fees on some mutual funds with the implication being that we’re paying for the additional returns attributable to the fund manager’s skill; however, most index benchmarks actually beat asset managers a vast majority of the time.

Alpha of a security

Alpha is also used to compare stock performance relative to an index of the sector or industry that it is in. This allows us to quickly see how the stocks we own have been doing relative to their peers. 

Using alpha

We can only compare apples to apples. So the alpha of a stock or a fund needs to be compared to a benchmark or index that has similar risks. It wouldn’t make sense to determine the alpha of a stock relative to a bond index. Stocks are riskier than bonds so we would expect them to have higher returns.

Also, we can only compare the alpha of different investments if those investments have similar risks. We can’t compare the alpha of a mutual fund that invests in stocks with the alpha of a mutual fund that invests in bonds.

Capturing alpha requires active investing but it can also be a buy or sell signal. Use alpha as a tool to evaluate the performance of your investments relative to what your expected return is as well as the return of similar investments. If you have stocks or funds that have a large positive or negative alpha, you’ll want to look into some news about the company to find out why it’s outperforming or underperforming. Depending on the news, it could be time to change your position and buy/sell.

There is no guarantee that an investment will produce alpha so, for most investors, a low-cost index-tracking ETF is often a better choice.

At Archimedes, our goal is to make investment literacy accessible and free for everyone.

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