Alpha is the excess return which can be made on an investment by singling out and targeting a specific risk or market anomaly. But besides being an additional return driver, many fund managers view alpha as a risk-control mechanism since different sources of alpha, or different risk factors, are often uncorrelated to one another. This applies even in times of crisis, when different investments and asset classes tend to re-correlate.As compensation for targeting a specific risk or market anomaly, investors seek a risk premium – or rate of return in excess of the return from risk-free investments. A positive risk premium relative to the market is associated with alpha.
Alpha measures the risk-adjusted returns or performance of investments relative to their benchmarks, such as the S&P 500 Index of large US stocks. Alpha can be pursued through an actively-managed investment strategy or through quantitative strategies which build indices and funds based on a set of financial rules.
Many analysts and fund managers believe alpha is a zero sum game across the market as a whole, since one investor’s excess return corresponds with another investor’s underperformance. Achieving alpha, then, requires an advantage over other investors, whether in the form of having greater information or a better investment model or strategy. Quantitative- or factor-based strategies are premised on the latter and aim to boost overall portfolio returns.
The need to control investment risk with an alpha strategy
Consider investing in an index that does not follow an alpha strategy, such as the S&P 500, which weights stocks based on their size (market capitalisation). These types of passive indices can become heavily weighted towards stocks which are expensive or towards stocks which are beginning to stagnate, thereby compromising future investment performance. They can also become overweight on certain industries, as was the case in the years leading up to the 2000 technology bubble.
Another example was the dominance of financial stocks in these indices in 2007, which led to a rapid decline in the S&P 500 Index when the bubble burst and investment banks including Lehman Brothers went bankrupt. The collapse of financial stocks dragged the S&P 500 Index from a high of 1,576 points on October 2007 to a closing value of 676 on March 9, 2009.
Mitigating risk by including an alpha strategy in a portfolio
An alpha strategy targets alpha returns from a number of different segments of the market and via different strategy types, resulting in a pool of alpha sources which are uncorrelated to one another. This diversification can improve risk-adjusted returns across an investment fund while also reducing volatility and controlling event risks, therefore lifting performance on a risk-adjusted basis.
Uncorrelated sources of alpha can span different asset classes, such as equity and fixed income markets, as well as varying styles or strategies, including a quantitative investment approach. In addition, an uncorrelated alpha component can straddle both developed and emerging market exposure, while also using different structures, such as long-only trades versus long-short positions.
Combining different alpha methodologies can also smooth out volatility risk within a fund since they tend to perform and underperform in different phases of market cycles. Momentum strategies – those which favour “hot stock” investments – tend to perform at different times to value strategies – those which favour relatively undervalued stocks or funds with upside potential, for example.
Many fund managers choose to split their total investment portfolios into separate alpha and beta funds. The beta portfolio allows investors to passively generate long-term returns, while the alpha portfolio provides uncorrelated returns and can boost total performance or manage risk.
Total return is a function of returns derived from market movements (beta), plus excess return (alpha).
As such, alpha measures the value which a fund manager adds or detracts from a portfolio’s return. With the rise of alternative, semi-passive sources of alpha, fund managers are under greater scrutiny for the role they can play in generating alpha versus the fees they charge.