Alpha (investment)
Encyclopedia
Alpha is a risk
-adjusted measure of the so-called active return on an investment
. It is the return in excess of the compensation for the risk borne, and thus commonly used to assess active managers
' performances. Often, the return of a benchmark is subtracted in order to consider relative performance, which yields Jensen's alpha
.
The alpha coefficient (
) is a parameter in the capital asset pricing model
(CAPM). It is the intercept of the security characteristic line
(SCL), that is, the coefficient of the constant in a market model
regression.
It can be shown that in an efficient market, the expected value of the alpha coefficient is zero. Therefore the alpha coefficient indicates how an investment has performed after accounting for the risk it involved:
For instance, although a return of 20% may appear good, the investment can still have a negative alpha if it's involved in an excessively risky position.
. Many academics felt that this was due to the stock market
being "efficient" which means that since so many people were paying attention to the stock market all the time, the prices of stocks rapidly moved to the correct price at any one moment, and that only random variation beyond the control of the manager made it possible for one manager to achieve better results than another, before fees or taxes were considered.
A belief in efficient markets spawned the creation of market capitalization weighted index funds that seek to replicate the performance of investing in an entire market in the weights that each of the equity securities comprises in the overall market. The best examples for the US are the S&P 500
and the Wilshire 5000
which approximately represent the 500 most widely held equities and the largest 5000 securities respectively, accounting for approximately 80%+ and 99%+ of the total market capitalization of the US market as a whole.
In fact, to many investors, this phenomenon created a new standard of performance that must be matched: an investment manager should not only avoid losing money for the client and should make a certain amount of money, but in fact should make more money than the passive strategy of investing in everything equally (since this strategy appeared to be statistically more likely to be successful than the strategy of any one investment manager). The name for the additional return above the expected return
of the beta adjusted return of the market is called "Alpha".
Although the strategy of investing in every stock appeared to perform better than 75 percent of investment managers, the price of the stock market as a whole fluctuates
up and down, and could be on a downward decline for many years before returning to its previous price.
The passive strategy appeared to generate the market-beating return over periods of 10 years or more. This strategy may be risky for those who feel they might need to withdraw their money before a 10-year holding period, for example. Thus investment managers who employ a strategy which is less likely to lose money in a particular year are often chosen by those investors who feel that they might need to withdraw their money sooner.
Investors can use both alpha and beta to judge a manager's performance. If the manager has had a high alpha, but also a high beta, investors might not find that acceptable, because of the chance they might have to withdraw their money when the investment is doing poorly.
These concepts not only apply to investment managers, but to any kind of investment.
Risk
Risk is the potential that a chosen action or activity will lead to a loss . The notion implies that a choice having an influence on the outcome exists . Potential losses themselves may also be called "risks"...
-adjusted measure of the so-called active return on an investment
Investment
Investment has different meanings in finance and economics. Finance investment is putting money into something with the expectation of gain, that upon thorough analysis, has a high degree of security for the principal amount, as well as security of return, within an expected period of time...
. It is the return in excess of the compensation for the risk borne, and thus commonly used to assess active managers
Active management
Active management refers to a portfolio management strategy where the manager makes specific investments with the goal of outperforming an investment benchmark index...
' performances. Often, the return of a benchmark is subtracted in order to consider relative performance, which yields Jensen's alpha
Jensen's alpha
In finance, Jensen's alpha is used to determine the abnormal return of a security or portfolio of securities over the theoretical expected return....
.
The alpha coefficient (
) is a parameter in the capital asset pricing modelCapital asset pricing model
In finance, the capital asset pricing model is used to determine a theoretically appropriate required rate of return of an asset, if that asset is to be added to an already well-diversified portfolio, given that asset's non-diversifiable risk...
(CAPM). It is the intercept of the security characteristic line
Security characteristic line
Security characteristic line is a regression line, plotting performance of a particular security or portfolio against that of the market portfolio at every point in time. The SCL is plotted on a graph where the Y-axis is the excess return on a security over the risk-free return and the X-axis is...
(SCL), that is, the coefficient of the constant in a market model
Capital asset pricing model
In finance, the capital asset pricing model is used to determine a theoretically appropriate required rate of return of an asset, if that asset is to be added to an already well-diversified portfolio, given that asset's non-diversifiable risk...
regression.
It can be shown that in an efficient market, the expected value of the alpha coefficient is zero. Therefore the alpha coefficient indicates how an investment has performed after accounting for the risk it involved:
: the investment has earned too little for its risk (or, was too risky for the return)
: the investment has earned a return adequate for the risk taken
: the investment has a return in excess of the reward for the assumed risk
For instance, although a return of 20% may appear good, the investment can still have a negative alpha if it's involved in an excessively risky position.
Origin of the concept
The concept and focus on Alpha comes from an observation increasingly made during the middle of the twentieth century, that around 75 percent of stock investment managers did not make as much money picking investments as someone who simply invested in every stock in proportion to the weight it occupied in the overall market in terms of market capitalization, or indexingIndex fund
An index fund or index tracker is a collective investment scheme that aims to replicate the movements of an index of a specific financial market, or a set of rules of ownership that are held constant, regardless of market conditions.-Tracking:Tracking can be achieved by trying to hold all of the...
. Many academics felt that this was due to the stock market
Stock market
A stock market or equity market is a public entity for the trading of company stock and derivatives at an agreed price; these are securities listed on a stock exchange as well as those only traded privately.The size of the world stock market was estimated at about $36.6 trillion...
being "efficient" which means that since so many people were paying attention to the stock market all the time, the prices of stocks rapidly moved to the correct price at any one moment, and that only random variation beyond the control of the manager made it possible for one manager to achieve better results than another, before fees or taxes were considered.
A belief in efficient markets spawned the creation of market capitalization weighted index funds that seek to replicate the performance of investing in an entire market in the weights that each of the equity securities comprises in the overall market. The best examples for the US are the S&P 500
S&P 500
The S&P 500 is a free-float capitalization-weighted index published since 1957 of the prices of 500 large-cap common stocks actively traded in the United States. The stocks included in the S&P 500 are those of large publicly held companies that trade on either of the two largest American stock...
and the Wilshire 5000
Wilshire 5000
The Wilshire 5000 Total Market Index, or more simply the Wilshire 5000, is a market-capitalization-weighted index of the market value of all stocks actively traded in the United States. Currently, the index contains over 4,100 components...
which approximately represent the 500 most widely held equities and the largest 5000 securities respectively, accounting for approximately 80%+ and 99%+ of the total market capitalization of the US market as a whole.
In fact, to many investors, this phenomenon created a new standard of performance that must be matched: an investment manager should not only avoid losing money for the client and should make a certain amount of money, but in fact should make more money than the passive strategy of investing in everything equally (since this strategy appeared to be statistically more likely to be successful than the strategy of any one investment manager). The name for the additional return above the expected return
Expected return
The expected return is the weighted-average outcome in gambling, probability theory, economics or finance.It isthe average of a probability distribution of possible returns, calculated by using the following formula:...
of the beta adjusted return of the market is called "Alpha".
Relation to beta
Besides an investment manager simply making more money than a passive strategy, there is another issue:Although the strategy of investing in every stock appeared to perform better than 75 percent of investment managers, the price of the stock market as a whole fluctuates
Conjuncture
In general, a conjuncture is a period marked by some watershed event which separates different epochs.In economics, conjuncture is a critical combination of events....
up and down, and could be on a downward decline for many years before returning to its previous price.
The passive strategy appeared to generate the market-beating return over periods of 10 years or more. This strategy may be risky for those who feel they might need to withdraw their money before a 10-year holding period, for example. Thus investment managers who employ a strategy which is less likely to lose money in a particular year are often chosen by those investors who feel that they might need to withdraw their money sooner.
Investors can use both alpha and beta to judge a manager's performance. If the manager has had a high alpha, but also a high beta, investors might not find that acceptable, because of the chance they might have to withdraw their money when the investment is doing poorly.
These concepts not only apply to investment managers, but to any kind of investment.
Further reading
- Bruce J. Feibel. Investment Performance Measurement. New York: Wiley, 2003. ISBN 0-471-26849-6
External links
- http://www.businessvaluation.us International Association of CPAs, Attorneys, and Management (IACAM) (Free Business Valuation E-Book Guidebook)]
- The financial-dictionary entry on alpha - the first definition from Duke finance professor Campbell Harvey is particularly helpful.
- Alpha Definition at Investopedia
- http://www.forexbasecamp.com/advanced-forex-concepts/five-technical-risk-ratios-in-forex-trading - Five Technical Risk Ratios