Quick Answer
Alpha is the excess return a security or portfolio earned relative to what the Capital Asset Pricing Model (CAPM) predicted for its level of risk. Positive alpha signals manager skill; beating the market's raw return does not by itself mean positive alpha, since higher returns can simply reflect higher beta.
Beta tells you how much systematic risk a security carries. Alpha tells you whether the returns justified that risk. Together, they provide a complete picture of risk-adjusted performance.
What Does Alpha Measure?
- Alpha measures the excess return of a security or portfolio relative to its expected return based on its level of risk (as predicted by the Capital Asset Pricing Model, or CAPM)
- Also called Jensen's alpha (named after economist Michael Jensen)
- Formula: Alpha = Actual return - Expected return (from CAPM)
| Alpha Value | Meaning |
|---|---|
| Positive alpha | The investment outperformed its risk-adjusted expected return (the manager added value) |
| Zero alpha | The investment performed exactly as expected for its level of risk |
| Negative alpha | The investment underperformed its risk-adjusted expected return (the manager destroyed value) |
Why Does Positive Alpha Indicate Manager Skill?
- Positive alpha indicates skill; the portfolio manager generated returns above what the market risk alone would predict
- Index funds, by design, aim for alpha of approximately zero (they match the market return, minus fees)
- Alpha is used to evaluate active portfolio managers. Consistent positive alpha suggests the manager is adding value beyond simply taking on market risk
- A manager who generates high returns solely by taking on more risk (higher beta) may have zero or negative alpha despite impressive raw returns
Why Aren't Raw Returns Enough to Judge Alpha?
Exam Tip: Gotchas
- Beating the market does NOT mean positive alpha. A fund that returned 15% when the market returned 10% may still have negative alpha once you account for risk.
- Example: Fund beta = 2.0, risk-free rate = 3%. CAPM expected return = 3% + 2.0(10% - 3%) = 17%. Alpha = 15% - 17% = -2%. The fund took on double the market risk but still fell short of what that risk level should have delivered.
The lesson: Always calculate the CAPM expected return before determining alpha. A higher return does not automatically mean positive alpha.
What Should You Check on Exam Day?
- Alpha = actual return minus the CAPM-expected return for that level of risk.
- Positive alpha signals manager skill; zero alpha means the investment performed exactly as its risk level predicted; negative alpha means it underperformed.
- Beating the market's raw return is not the same as positive alpha; a higher beta can produce a higher raw return with negative alpha.
- Always calculate the CAPM expected return first, then subtract it from the actual return to get alpha.