Alpha
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.
Definition and Interpretation
- 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) |
What Alpha Really Measures
- 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
The Alpha Trap: Raw Returns Are Not Enough
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.