Alpha (investment) Totally Explained

Everything about Alpha Investment totally explained

Alpha is a risk-adjusted measure of the so-called active return on an investment. It is a common measure of assessing an active manager's performance as it's the return in excess of a benchmark index. Note that the term "active return" refers to the return over a specified benchmark (for example the S&P500), whereas "excess return" refers specifically to the return over the risk-free rate. It is a common error to confound these two terms, and the reader is cautioned to make a careful distinction between them when studying or discussing investments.
The difference between the fair and actually expected rates of return on a stock is called the stock's alpha.
The alpha coefficient (

alpha_i

) is a parameter in the capital asset pricing model. In fact it's the intercept of the Security Characteristic Line (SCL). One can prove that in an efficient market, the expected value of the alpha coefficient equals the return of the risk free asset:

E(alpha_i) = r_f

.
Therefore the alpha coefficient can be used to determine whether an investment manager or firm has created economic value:

$alpha_i < r_f$ : the manager or firm has destroyed value
$alpha_i = r_f$ : the manager or firm has neither created nor destroyed value
$alpha_i > r_f$ : the manager or firm has created value

The difference

alpha_i - r_f

is called Jensen's alpha.

Origin of the concept

The concept and focus on Alpha comes from an observation increasingly made during the middle of the twentieth century, that around 75 percent of stock investment managers didn't make as much money picking investments as someone who simply invested in every stock in proportion to the weight it occupied in the overall market in terms of market capitalization, or indexing. Many academics felt that this was due to the stock market being "efficient" which means that since so many people were paying attention to the stock market all the time, the prices of stocks rapidly moved to the correct price at any one moment, and that only luck made it possible for one manager to achieve better results than another, before fees or taxes were considered. A belief in efficient markets spawned the creation of market capitalization weighted index funds that seek to replicate the performance of investing in an entire market in the weights that each of the equity securities comprises in the overall market. The best examples are the S&P 500 and the Wilshire 5000 which approximately represent the 500 largest equities and the largest 5000 securities respectively, accounting for approximately 80%+ and 99%+ of the total market capitalization of the US market as a whole.
In fact, to many investors, this phenomenon created a new standard of performance that must be matched: an investment manager shouldn't only avoid losing money for the client and should make a certain amount of money, but in fact should make more money than the passive strategy of investing in everything equally (since this strategy appeared to be statistically more likely to be successful than the strategy of any one investment manager). The name for the additional return above the expected return of the beta adjusted return of the market is called "Alpha".

Relation to beta

Besides an investment manager simply making more money than a passive strategy, there's another issue: ť Although the strategy of investing in every stock appeared to perform better than 75 percent of investment managers, the price of the stock market as a whole fluctuates up and down, and could be on a downward decline for many years before returning to its previous price.

The passive strategy appeared to generate the market-beating return over periods of 10 years or more. This strategy may be risky for those who feel they might need to withdraw their money before a 10-year holding period, for example. Thus investment managers who employ a strategy which is less likely to lose money in a particular year are often chosen by those investors who feel that they might need to withdraw their money sooner. The measure of the correlated volatility of an investment (or an investment manager's track record) relative to the entire market is called beta. Note the "correlated" modifier: an investment can be twice as volatile as the total market, but if its correlation with the market is only 0.5, its beta to the market will be 1.
Investors can use both alpha and beta to judge a manager's performance. If the manager has had a high alpha, but also a high beta, investors might not find that acceptable, because of the chance they might have to withdraw their money when the investment is doing poorly.
These concepts not only apply to investment managers, but to any kind of investment.

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