Is a high alpha always good?

A high alpha over a short period can be down to chance rather than a repeatable process. Alpha is most meaningful to look at over several years, together with an understanding of why the return deviated.

How does alpha differ from ordinary return?

Ordinary return tells you how much the money grew. Alpha isolates the part of the return that can't be explained by the portfolio simply taking on market risk (beta). Two funds with the same return can have different alphas if they took on different amounts of market risk to get there.

Glossary

Alpha

The return a portfolio has delivered beyond what its market risk and the risk-free rate can explain, according to the CAPM financial model.

What it is

The part of the return beta doesn't explain

Alpha is derived through CAPM (the Capital Asset Pricing Model): expected return equals the risk-free rate plus the portfolio's beta multiplied by the index's excess return. Alpha is the difference between the actual return and what the model predicted. A positive alpha means the portfolio performed better than its market risk alone explains. A negative alpha means the opposite, regardless of how the return looked in absolute terms.

Positive alpha: The portfolio has delivered return beyond what market risk explains, a sign that active choices contributed positively.
Negative alpha: The portfolio has performed worse than what market risk predicted, regardless of whether the actual return was positive or negative.
Alpha assumes a correct beta: The entire calculation rests on the portfolio's beta against the same index. A short measurement period gives an uncertain beta, and therefore an uncertain alpha.

In practice

A measure of skill, not of luck

Alpha isolates the part of the return that isn't explained by the portfolio taking on market risk, which makes it useful for comparing managers with different betas against the same index. Two managers with the same return can have entirely different alphas if one took on considerably more market risk to get there. The calculation rests entirely on a correctly estimated beta, though, and a short measurement period gives an uncertain beta and therefore an uncertain alpha. Alpha should always be read across several periods rather than as a single figure, together with an explanation of why the return actually deviated.

“The company's profits, not the next buyer's optimism.”

Amos Fonder

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Common questions about alpha

: A high alpha over a short period can be down to chance rather than a repeatable process. Alpha is most meaningful to look at over several years, together with an understanding of why the return deviated.
: Ordinary return tells you how much the money grew. Alpha isolates the part of the return that can't be explained by the portfolio simply taking on market risk (beta). Two funds with the same return can have different alphas if they took on different amounts of market risk to get there.

Related concepts

Glossary

Information ratio

How much excess return a portfolio has delivered against its benchmark, set in relation to how much it deviated to get there.

Effective number of assets

A concentration measure showing how many equally-weighted holdings a portfolio is equivalent to, regardless of how many companies it actually owns.

Margin of safety

The difference between a company's intrinsic value and its market price. The foundation of thinking about risk and asymmetric return.

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