Whiteboard Video Series: What is Alpha?
Watch this short 3-minute educational video to learn more about alpha and what it means for your client portfolios.
As part of our ongoing University of Alts content library, today we're going to cover Alpha.
As always, we'll start with a definition. Alpha measures the risk-adjusted performance of a fund in relation to its benchmark. It can also be defined as the difference between a fund's actual returns and those that would have been expected at its given level of risk as measured by beta. For this reason, we will want to see an alpha metric that is greater than zero, with larger numbers indicating greater risk-adjusted performance.
Next, let's talk about why this is an important metric to take into consideration, particularly when comparing funds in the alternative space. To determine if an investment manager is adding value on an apples-to-apples basis against a passive index or other managers in their peer group, we must look not only at the portfolio's absolute return, but also whether investors are being rewarded for the amount of risk they are taking to achieve this return. For this reason, alpha is often interpreted as the value that a fund manager adds beyond the types of results that could have been achieved by investing in a passive index.
The importance of taking into account both returns and risk when analyzing investment options is highlighted in the following example. First, let's start with the formula for calculating alpha. As you can see, we will need four variables to complete this equation: the return of the subject portfolio, the return of the market or index, the risk-free rate, and beta.
For this example, we will compare two portfolios: Fund A, which returned 10% with a beta of 0.8; and Fund B, which delivered a higher absolute return of 12%, but with a beta of 1.2. For the purposes of the calculation, we will assume a benchmark return of 10% and a risk-free rate of 2%.
Once we fill in the respective variables, we can see an interesting result develop. Despite Fund B outperforming Fund A on an absolute basis, when you take into consideration the additional risk it took to achieve this return, Fund A was actually able to deliver a greater alpha.
While this doesn't provide an answer to which fund is objectively better, it may be important to consider as you build client portfolios and allocate within a defined risk budget, knowing that alpha is a metric that can lead you to the funds that deliver the greatest return relative to their overall risk exposure.