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Alpha                                                               

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  1. Definition
  2. Examples, Types, or Variations
  3. Formula
  4. Related Terms
  5. As Used in the Hedge Fund World
  6. Applications
  7. Misused & Abused
  8. Additional Sources of Information
    1. Books
    2. News
    3. Scholarly Papers
       
 

1.
 

Definition
 
  Alpha is a risk-adjusted measure of the so-called "excess return" on an investment. It is a common measure of assessing an active manager's performance as it is the return in excess of a benchmark index or "risk-free" investment.

The difference between the fair and actually expected rates of return on a stock is called the stock's alpha.

The concept and focus on Alpha comes from an observation increasingly made during the middle of the twentieth century, that around 75% of stock investment managers did not make as much money picking investments as someone who had simply invested in every stock in proportion to the weight it occupied in the overall market in terms of market capitalization, or indexing. 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 luck 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 are the S&P 500 and the Wilshire 5000 which approximately represent the 500 largest equities and the largest 5,000 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".


Other Resources:

  • Brandywine Asset Management: A measure of the difference between a portfolio's actual returns and its expected performance, given its level of risk as measured by beta. More…
     
  • Investrade: Alpha measures the difference between the fund's actual results and the results one would expect from a statistically average fund having the same beta in the same category. More…
     
  • Light Green Advisors: Synonym of 'value added', linearly similar to the way beta is computed, alpha is the incremental return on a manager when the market is stationary. More…
     

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2.
 

Examples, Types, or Variations
 
  a. Jensen's Alpha or Jensen's Measure
  • In finance, Jensen's alpha (or Jensen's Performance Index) is used to determine the excess return of a stock, other security, or portfolio over the security's required rate of return as determined by the Capital Asset Pricing Model. This model is used to adjust for the level of beta risk, so that riskier securities are expected to have higher returns. The measure was first used in the evaluation of mutual fund managers by Michael Jensen in the 1970's.

b. Portable Alpha

  • Portable alpha is an investment management term which refers to the return of an investment manager who has intentionally and completely eliminated his market risk, or beta. The return of such a portfolio will only represent the manager's skill in selecting investments within the market, and will be independent of the direction or magnitude of the market's movement. The elimination of market risk can be accomplished through use of futures, swaps, options, or short selling.

c. Weighted Alpha

  • A weighted measure of how much a stock has risen or fallen over a certain period, usually a year.

Other Resources:
 

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3.
 

Formula
 
  The Formula for Alpha is:
 

a.

[ (sum of y) - ((b)(sum of x)) ] / n
   

 

Where:
n = number of observations (36 mos.)
b = beta of the fund
x = rate of return for the market
y = rate of return for the fund

 
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4.
 

Related Terms
 
 
  • Beta
  • CAPM
  • Jensen's Alpha
  • Portable Alpha
  • Weighted Alpha
     

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5.
 

As Used in the Hedge Fund World
 
  Alpha often refers to the “skill based” returns of a manager. Beta in contrast refers to the market based returns of an asset class.

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 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. The measure of the correlated volatility of an investment (or an investment manager's track record) relative to the entire market is called beta. Note the "correlated" modifier: an investment can be twice as volitle as the total market, but if its correlation with the market is only 0.5, its beta to the market will be 1.

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.

Other Resources:

  • European Pensions & Investment News: The Decline of Alpha. Do hedge funds rely solely on alpha as their source of return? More…
     
  • Managed Funds Association: An MPT approach to hedge funds requires an accurate aggregate benchmark of all hedge funds as well as style and cluster benchmarks and the calculation of each manager’s “hedge fund beta” (HF beta) and “hedge fund alpha” (HF alpha). More…
     

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6.
 

Applications
 
  Did the manager deliver value; did his/her management deliver extra value, i.e. return on a risk adjusted basis compared to what could be achieved specifically elsewhere; is the investor paying a fee that is justified by the Alpha? An Alpha of 2 means that the manager exceeded the performance of the benchmark by 2%. A benchmark that is frequently referenced as “the market” (the colloquial of market can represented by the S&P 500 or other major indices). Therefore an Alpha of 2% means that the investor was rewarded with this extra alpha vs. accepting the return inherent in the market.

Other Resources:

  • Hedge Fund Intelligence: Mike Thomas, Russell Investment Group: Alpha can be transported in a number of different ways, although before it can be transported it needs to be isolated. More…
     

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7.
 

Misused & Abused
 
 
  1. If a fund manager makes 8% on a superior risk adjusted basis than the S&P which may have made 12% over a comparable period, the following questions arise:
   
  • Is the S&P a comparable or appropriate market to be compared against?
  • Can the manager in this scenario claim to have generated alpha relative to the S&P?
  • If the manager made 14% return, did the manager necessarily producing alpha because he or she is outperforming the S&P based on return? Are managers or marketers misappropriating this already misunderstood term in this manner?
  • Does everyone calculate Alpha in the same manner or we using the same word or different yard sticks?
  • Professor Schneeweis weighs in on some of these questions in an excellent paper “Alpha, Alpha, Whose got the Alpha?” at www.cisdm.som.umass.edu/research/pdffiles/alpha.pdf

    The following are excerpts from Professor Schneeweis' paper...
   
  • Each manager and investor has his or her own unique take on what alpha is how it should be measured.
  • The Alpha term is important in finance because it represents the return that the investor would receive if the benchmark had a zero return”.
  • “it is the return adjusted for the risk of a comparable riskly asset or portfolio. The question is therefore how to define the expected risk of the manager’s investment postion and how to obtain the return on a comparable risk position or position.
  • The failure of any single theoretical model [such as the Modern Portfolio Theory, The CAPM, or the Arbitrage Price Theory] in a testable form leaves us with statistical, rather than theoretical approaches to estimate a security’s or strategy’s expected return.
  • It is not appropriate to say that you have a positive alpha (net risk adjusted return) simply because the return is greater than the risk free rate unless your portfolio is risk free. Similarly comparing the return to the S&P 500 or any other benchmark is inappropriate unless your strategy responds only to the same return drivers that drive the S&P 500 or the cited benchmark.
  • One should never mistake a ‘marketing’ alpha from a relative performance alpha. If the manager chose asset positions with a higher return to some comparable naïve position then that person can be said to achieve a positive alpha. Managers may say that investor’s never care about relative return but only absolute return. But the performance alpha is all about proper measured return. Unfortunately, we have no simple method for establishing this benchmark except under vary restrictive situations.
  Other Resources:
  • Hedge Fund Center: For EDHEC, this approach to hedge fund performance in terms of pure alphas has not been proven, and it would be more appropriate instead to consider that it is the betas and the managers’ capacity to take properly rewarded risks that contribute to the essential part of their performance. More…
     
  • Canadian Investment Review: A corollary to the notion that there is substantial beta in hedge fund returns is the idea that we must have a better notion of alpha being delivered by the manager. More…
     
  • Journal of Financial Planning: Because of a manager’s freedom to trade in multiple markets, take long and short positions, and use varying degrees of leverage, they can structure a portfolio that is exposed to a variety of risk factors beyond general market exposures. More…
     

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8.
 

Additional Sources of Information
 
 
  1. Books
  2. News
  3. Scholarly Papers

 

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