Alpha is a financial risk ratio which can be used to predict returns from holding an investment. Alpha can be seen as a measure of the value created by active fund management or by an alternative index provider.
Alpha strategies (sometimes in the form of risk premia)
In a long-only fund, alpha gauges the performance of an investment by comparing it to a relevant benchmark, a common example of which is the S&P 500 Index of large US equity stocks. Naturally, investors often prefer a high level of alpha, which has a baseline number of zero. A positive alpha of 1%, for example, indicates that a fund or share has outperformed its benchmark by 1%. Conversely, a negative alpha means the investment underperformed.
Beta, meanwhile, measures how an investment responds to the ups and downs of the equity market. Put differently, beta shows how volatile an investment is compared to the market. Beta exposure is measured relative to a benchmark index like the S&P 500.
Beta refers to the return generated from a financial investment which can be attributed to market returns, while alpha quantifies the portion of return derived from idiosyncratic risks – or those which are specific to a certain equity stock or investment class and are therefore independent from the broader market.
This means that beta is a proxy for exposure to systematic risk, unlike alpha (idiosyncratic risk).
For these reasons, it is usually easy to generate beta returns, while alpha is much more difficult and only the best fund managers and strategies can deliver alpha over the long run. Basically, alpha is the reason why investors pay for quality fund managers or strategies.
Beta’s baseline is one, where one indicates that a stock or fund will move exactly in toe with the benchmark or market. A beta of less than one implies that an investment is less volatile than the benchmark, while a reading above one points to above-average volatility based on past performance.
For example, a fund with a beta value of 1.2 (meaning it is more volatile than its benchmark) would be expected to yield a 12% return if the benchmark’s return over that period is 10%.
Since alpha and beta are both based on historical performance, they are, of course, unable to predict future returns – though they can help investors identify those stocks or funds which tend to perform well on a risk-adjusted basis.
While many investors favour high alpha and low beta ratios, an investor with an appetite for risk might favour high-alpha high-beta funds since these capitalise on upside volatility.
An investor can manage the risks of an equity portfolio by separating it into two funds – a beta portfolio and an alpha component. The beta portion of the overall portfolio will passively move with the market, the closeness of which will be dependent on its correlation to the market. The alpha portion on the other hand will seek to generate above-average returns from risks which are uncorrelated to the market.
In short, alpha is targeted through active fund management (or an active slant on passive investments, such as smart beta products), while beta is achieved from exposure to the overall market.
The beta of an investment fund can be approximated by untailored online investment tools. Investors can, however determine beta themselves through a relatively simple, though sometimes time-consuming, regression analysis based on past performance relative to the market.
Alpha, on the other hand, can be calculated as follows:
Alpha = PR – [RF + Beta*(MR – RF)]
PR is the return from the portfolio
RF is the risk-free rate of return, for example return from investing in a government bond
MR is the return generated by the market
Alpha and beta are one of many
measures of risk and return
which investors use to make informed investment decisions.
Many investors use alpha strategies in their portfolios as a source of diversification and as additional value drivers, through active fund management techniques that sometimes include hedge funds and risk premia.