Alpha Alpha: What Is 'Alpha' What Is 'Alpha'

1/28/2017 Alpha
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What is 'Alpha'
Alpha is used in finance to represent two things:
1. A measure of performance on a risk-adjusted basis.
Alpha, often considered the active returnon

returnon an investment, gauges the
performance of an investment against a market index used as a benchmark
benchmark,,
since they are often considered to represent the markets movement as a
whole. The excess returns of afund
afund relative to the return of a benchmark
PROMOTE CONTENT ON TIMES OF INDIA NETWORK
indexis
index is the fund's alpha.
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Alpha is most often used for mutual funds and other similar investment
00:10 01:29
types. It is often represented as a single number (like 3 or -5), but this refers
to a percentage measuring how the portfolio or fund performed compared to
the benchmark index (i.e. 3% better or 5% worse).
Alpha is often used with beta

beta,, which measuresvolatility
measuresvolatility or risk
risk,, and is also often referred to as
excess return or abnormal
abnormal rate of return.
return.
2. The abnormal rate of return on a security or portfolio in excess of what would be predicted by an
equilibrium model like the capital asset pricing model (CAPM).
(CAPM).
In this context, alpha is often known as the Jensen index.
BREAKING DOWN 'Alpha'

1. Alpha is one of five technical risk ratios;
ratios; the others are beta, standard deviation,
deviation, R-squared
R-squared,, and
the Sharpe ratio.
ratio. These are all statistical measurements used in modern portfolio theory (MPT).
(MPT). All
of these indicators are intended to help investors determine the risk-return profile of a mutual fund.
Using alpha in measuring performance assumes that the portfolio is sufficiently diversified so as to
eliminate unsystematic risk.
risk. Because alpha represents the performance of a portfolio relative to a
benchmark, it is often considered to represent the value that a portfolio manager adds to or
subtracts from a fund's return. In other words, alpha is the return on an investment that is not a
result of general movement in the greater market. As such, an alpha of 0 would indicate that the
portfolio or fund is tracking perfectly with the benchmark index and that the manager has not
added or lost any value.
The concept of alpha was born with the advent of weighted index funds like the S&P 500 for the
stock market and the Wilshire 5000 for the securities market,
market, which attempt to emulate the
performance of a portfolio that encompasses the entire market and that gives each area of Trading Center
investment proportional weight. With this development, investors could hold their portfolio
managers to a higher standard of just producing returns: producing returns greater than the investor
would have made with a blanket market-wide portfolio.
Yet, despite the considerable desirability of alpha in a portfolio, index benchmarks manage to beat
asset managers the vast majority of the time.
time. Due in part to a growing lack of faith in traditional
financial advising brought about by this trend, more and more investors are switching to low-cost
passive online advisors
advisors(often
(often called robo-advisors) who exclusively or almost exclusively invest
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1/28/2017 Alpha
clients capital into index-tracking funds,
funds, the thought being that if they cannot beat the market they
may as well join it.

Moreover, because most traditional financial advisors charge a fee, when one manages a portfolio
and nets an alpha of 0, it actually represents a slight netloss for the investor. For example, suppose
that Jim, a financial advisor, charges 1% of a portfolios value for his services and that during a 12-
month period Jim managed to produce an alpha of 0.75 for portfolio of one of his clients, Frank.
While Jim has indeed helped the performance of Franks portfolio, the fee that Jim charges is in
excess of the alpha he has generated, so Franks portfolio has experienced a net loss. Because of
these developments, managers face more pressure than ever to produce results.
Evidence shows that active managers rates of achieving alpha in funds and portfolios have been
shrinking substantially, with about 20% of managers producing statistically significant alpha in 1995
and only 2% in 2015.
2015. Experts attribute this trend to many causes, including:
The growing expertise of financial advisors

Advancements in financial technology and software thatadvisors have at their disposal
Increasing opportunity for would-be investors to engage in the market due to the growth of the
internet
A shrinking proportion of investors taking on risk in their portfolios and
The growing amount of money being invested in pursuit of alpha
2. CAPM analysis aims to estimate returns on a portfolio or fund based on risk and other factors. For
example, aCAPManalysis may estimate that a portfolio should earn 10% based on the portfolios
risk profile.
profile. Yet, supposing that the portfolio actually earns 15%, the portfolio's alpha would be 5, or
5% over what was predicted in theCAPMmodel.
This form of analysis is often used in non-traditional funds, which are less easily represented by a
single index.
Limitations of 'Alpha'
While alpha has beencalled
beencalled the holy grail of investing and, as such, receives a lot of attention from
investors and advisors alike, there are a couple of important considerations that one should take
into account before attempting to use alpha.
One such consideration is that alpha is used in the analysis of a wide variety of fund and portfolio
types. Because the same term can apply to investments of such differing natures, there is a tendency
for people to attempt to use alpha values to compare different kinds funds or portfolios with one
another. Because of the intricacies of large funds and portfolios, as well as of these forms of
investing in general, comparing alpha values is only useful when the investments contain assets in
the same asset class.
class.
Additionally, because alpha is calculated relative to a benchmark deemed appropriate for the fund
or portfolio, when calculating alpha it is imperative that an appropriate benchmark is chosen.
Because funds and portfolios vary, it is possible that there is no suitable preexisting index, in which
case advisors will often use algorithms and other models to simulate an index for comparative
purposes.
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Portable Alpha
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A strategy in which portfolio managers separate alpha from beta by investing in securities that differ
from the market index from which their beta is derived. Alpha is the return achieved over and above
the return that results from the correlation between the portfolio and the market (beta). In simple
terms, portable alpha is a strategy that involves investing in areas that have little to no correlation
with the market.
BREAKING DOWN 'Portable Alpha'

Portfolio return is based on two aspects. The first is beta, which is the extent to which an investment
vehicle moves with the market and can be said to represent passive returns, which occur as a result
of an increase along with the overall market. The second is alpha, which is a measure of a manager's
ability to generate returns by choosing stocks or other investments that will outperform the market
in a given time period, and can be said to represent the returns generated by active-management
techniques.
If a portfolio manager can improve alpha by investing in securities that are not correlated with the
beta of an existing portfolio, that manager will have created a portable alpha.
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Alpha Generator
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Any security that, when added to an existing portfolio of assets, generates excess returns or returns
higher than a pre-selected benchmark without additional risk. An alpha generator can be any
security; this includes government bonds,
bonds, foreign stocks, or derivative products such as stock
options and futures.
BREAKING DOWN 'Alpha Generator'

Keep in mind that alpha itself measures the returns a portfolio produces in excess of the return
originally estimated by the capital asset pricing model,
model, on a risk-adjusted basis. Therefore, an alpha
generator adds to portfolio returns without adding any additional risk, as measured by volatility or
downside volatility. This follows modern portfolio theory in allowing investors to maximize returns
while keeping a certain level of risk.

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Jensen's Measure
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The Jensen's measure is a risk-adjusted performance measure that represents the average return on
a portfolio or investment above or below that predicted by the capital asset pricing model (CAPM)
given the portfolio's or investment's beta and the average market return. This metric is also
commonly referred to as Jensen's alpha, or simply alpha.
BREAKING DOWN 'Jensen's Measure'

To accurately analyze the performance of an investment manager,
manager, an investor must look not only at
the overall return of a portfolio, but also at the risk of that portfolio to see if the investment's return
compensates for the risk it takes. For example, if two mutual funds both have a 12% return, a
rational investor should prefer the fund that is less risky. Jensen's measure is one of the ways to
determine if a portfolio is earning the proper return for its level of risk. If the value is positive, then
the portfolio is earning excess returns.
returns. In other words, a positive value for Jensen's alpha means a
fund manager has "beat the market" with his stock picking skills.
Jensen's Measure Calculation Example

Assuming the CAPM is correct, Jensen's alpha is calculated using the following four variables:
R(i) = the realized return of the portfolio or investment
R(m) = the realized return of the appropriate market index
1/28/2017 Alpha
R(f) = the risk-free rate of return for the time period
B = the beta of the portfolio of investment with respect to the chosen market index
Using these variables, the formula for Jensen's alpha is:
Alpha = R(i) - (R(f) + B x (R(m) - R(f)))
For example, assume a mutual fund realized a return of 15% last year. The appropriate market index
for this fund returned 12%. The beta of the fund versus that same index is 1.2 and the risk-free rate is
3%. The fund's alpha is calculated as:
Alpha = 15% - (3% + 1.2 x (12% - 3%)) = 15% - 13.8% = 1.2%.
Given a beta of 1.2, the mutual fund is expected to be riskier than the index, and thus earn more. A
positive alpha in this example shows that the mutual fund manager earned more than enough
return to be compensated for the risk he took over the course of the year. If the mutual fund only
returned 13%, the calculated alpha would be -0.8%. With a negative alpha, the mutual fund
manager would not have earned enough return given the amount of risk he was taking.
Tainted Alpha
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An alpha return that cannot be attributed solely to the money manager due to consequential beta
exposure. Tainted alpha is seen when money managers invest in individual equities, instead of using
market neutral strategies such as arbitrage, and hedging.
BREAKING DOWN 'Tainted Alpha'

1/28/2017 Alpha
Due to many individual investors being unable to invest in funds that use pure alpha strategies (i.e.
hedge funds), tainted alpha is common among the majority of managed portfolios. For most this is
acceptable, because of the benefits of passively capturing gains that are associated with long term
beta exposure, along with a money manager's stock picking ability.

Excess Returns
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Video Definition

Excess returns are investment returns from a security or portfolio that exceed the riskless rate on a
security generally perceived to be risk free, such as a certificate of deposit or a government-issued
bond. Additionally, the concept of excess returns may also be applied to returns that exceed a
particular benchmark or index with a similar level of risk.
BREAKING DOWN 'Excess Returns'

Determining the excess returns requires the subtracting of the riskless rate, or benchmark rate, from
the actual rate achieved. For example, if the current riskless rate is 1.2% and the portfolio being
examined received a return of 8%, the excess return would be the 6.8% difference. Excess returns
can be either positive or negative depending on the result of the equation. Positive excess returns
1/28/2017 Alpha
demonstrate the investment outperformed the riskless rate or benchmark, while negative excess
returns occur when an investment underperforms in comparison to the riskless rate or benchmark.

Widely used as a measure of the value added by the portfolio or investment manager or the
manager's ability to beat the market, excess returns may also be referred to as the alpha after being
adjusted by the risk assessed, known as the beta.
Alpha and Beta

The alpha and beta are both metrics relating to the level of risk or volatility experienced in a
particular security. While the alpha provides a measurement in regards to the assets performance,
the beta specifies the level of risk present when compared to the capital asset pricing model (CAPM).
Calculated using a form of regression analysis, the beta is a measure of the assets ability to respond
to market fluctuations.
For example, consider a large-cap U.S. mutual fund that has the same level of risk (i.e. beta = 1) as
the S&P 500 index. If the fund generates a return of 12% in a year when the S&P 500 has only
advanced 7%, the difference of 5% would be considered as excess return, or the alpha generated by
the fund manager.
manager.
Excess Returns and Long-Term Results

Critics of mutual funds and other actively managed portfolios contend that it is next to impossible to
generate excess returns on a consistent basis over the long term, as a result of which, most fund
managers underperform the benchmark index over time. Additionally, active funds often come with
higher fees that can negate a portion of the gains experienced by the investor.
This has led to the tremendous popularity of index funds and exchange-traded funds and has
resulted in some fund management companies, such as Legg Mason, offering additional hybrid
products. The new offerings are designed to attract investors who were inclined to pull their funds
out of managed funds and investing those funds into various index funds.
Dispersion
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Dispersion Topics Reference Advisors Markets Simulator
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Dispersion is a statistical term describing the size of the range of values expected for a particular
variable. In finance, dispersion is used in studying the effects of investor and analyst beliefs on
securities trading, and in the study of the variability of returns from a particular trading strategy or
investment portfolio
portfolio.. It is often interpreted as a measure of the degree of uncertainty, and thus risk,
associated with a particular security or investment portfolio.
BREAKING DOWN 'Dispersion'

For example, the familiar risk measurement, beta beta,, measures the dispersion of a security's returns
relative to a particular benchmark or market index.
index. If the dispersion is greater than that of the
benchmark, then the instrument is thought to be riskier than the benchmark. If the dispersion is
less, then it is thought to be less risky than the benchmark.
A beta measure of 1.0 indicates the investment moves in unison with the benchmark. A beta of 0
signifies no correlation, and a beta less than 0 shows contrary movement to the benchmark. For
example, if an investment portfolio has a beta of 1.0 using the S&P 500 as a benchmark, the
movement between the portfolio and benchmark is nearly identical. If the S&P 500 is up 10%, so is
the portfolio. On anegative beta, if the S&P 500 is up, the portfolio moves in the exact opposite
direction, which in this case will move down.
Standard Deviation
Standard deviation is another commonly used statistic for measuring dispersion. It is a simple way
to measure an investment or portfolio's volatility. The lower the standard deviation, the lower the
volatility. For example, a biotech stock has a standard deviation of 20.0% with an average return of
10%. An investor should expect the price of the investment to move 20% in either a positive or
negative manner away from the average return. In theory, the stock can fluctuate in value from
negative 10% to positive 30%. Stocks have the highest standard deviation, with bonds and cash
having much lower measures.
Alpha
Both beta and standard deviation are common measurements used to determine the dispersion of a
portfolio but often work independently of each other. Alpha is a statistic that measures a portfolio's
risk-adjusted returns. A positive number suggests the portfolio should get a positive return in
exchange for the risk level taken. A portfolio taking excessive risk and not getting a sufficient return
has an alpha of 0 or less. Alpha is a tool for investors looking to measure the success of a portfolio
manager. A portfolio manager with a positive alpha indicates a better return with either the same or
less risk than the benchmark.
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Appraisal Ratio
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A ratio used to measure the quality of a fund's investment picking ability. It compares the fund's
alpha (or the adjusted return of the fund assuming the market return is zero) to the portfolio's
unsystematic risk or residual standard deviation.
deviation.
BREAKING DOWN 'Appraisal Ratio'

By selecting a basket of investments, the managers of an active investment fund attempt to beat the
returns of a relevant benchmark or of the overall market. The appraisal ratio measures the
managers' performance by comparing the return of their stock picks to the specific risk of those
selections. The higher the ratio, the better the performance of the manager in question.
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1/28/2017 Alpha

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1. A measure of performance on a risk-adjusted basis.

Alpha, often considered the active returnon

Alpha is often used with beta

In this context, alpha is often known as the Jensen index.

BREAKING DOWN 'Alpha'

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The growing expertise of financial advisors

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BREAKING DOWN 'Portable Alpha'

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BREAKING DOWN 'Alpha Generator'

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BREAKING DOWN 'Jensen's Measure'

Jensen's Measure Calculation Example

R(i) = the realized return of the portfolio or investment

R(m) = the realized return of the appropriate market index

Using these variables, the formula for Jensen's alpha is:

Alpha = R(i) - (R(f) + B x (R(m) - R(f)))

Alpha = 15% - (3% + 1.2 x (12% - 3%)) = 15% - 13.8% = 1.2%.

BREAKING DOWN 'Tainted Alpha'

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BREAKING DOWN 'Excess Returns'

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Alpha and Beta

Excess Returns and Long-Term Results

Dispersion Topics Reference Advisors Markets Simulator

BREAKING DOWN 'Dispersion'

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BREAKING DOWN 'Appraisal Ratio'

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