What is Alpha and Why Should You Care?

While the term “alpha” is widely used, in our experience, it’s not particularly well understood. Alpha, properly defined, is return in excess of what could have been expected given the risks assumed to generate the returns. Notice that this is not strictly outperformance relative to a benchmark, but rather, its relative performance given the level of risk taken.

Factoring risk into the fund’s performance is an important distinction. A manager who outperforms a benchmark only by taking excessive risk may be a lucky beneficiary of a favorable market environment: in an up market, a fund with greater risk would be expected to outperform. Alpha gives context to the performance, and shows whether a manager’s performance exceeds expectations for a given risk level.

Over the past couple of decades, the tools and techniques that we use to measure performance, along with the increased availability and quality of data sets, have led us to understand that much of what we used to view as alpha was actually systematic exposure to a particular factor. Granted, 10-15 years ago investors had little in the way of vehicles to harvest premiums to value or quality or low volatility, for example. And so, active managers who correctly divined that companies/stocks exhibiting those qualities offered excess risk-adjusted returns were rewarded. That was certainly alpha at the time, because it took skill to identify the opportunity and to build a portfolio that capitalized on that insight, while managing risk appropriately.

However, today, those same risk premia can be harvested systematically and cheaply, and therefore calling them “alpha” is a stretch. So, does alpha still exist?

Yes, we believe there is still room to identify and capitalize on inefficiencies, albeit mostly (entirely?) in capacity constrained ways.

For one, behavioral finance has provided a treasure trove of ideas for capitalizing on the biases so clearly exhibited by investors. Whereas in the past an investor’s advantage came from doing more detailed work to understand financial statements and industry dynamics, the advantage going forward will come from understanding how investors process and act on that information.

Gravitating toward broader opportunity sets and freeing managers from the tyranny of the benchmark needs to be given serious consideration as well. After all, if investors are employing cheap beta products for much of their exposure, doesn’t it stand to reason that when employing active managers, constraints should be relaxed? Being afforded the flexibility to fully express all views on the securities researched improves investment efficiency because more of the information uncovered during the research process is acted upon.

Last but not least, risk management is most certainly an area where thoughtful, skilled investors can add value. Buying companies without regard to their valuation or fundamentals, as is the case with indexing, guarantees sub-optimal outcomes when markets inevitably roll over.

When selecting active managers, alpha can serve as a better gauge of a manager’s skill than simply examining excess returns.

Read our last blog post, The (Really) Long and Short of It >