Alpha refers to the excess returns earned on an investment above the benchmark or index return. It measures a portfolio manager's ability to generate returns beyond what would be expected from passive index investing.
Unlike beta (which measures volatility relative to the market), alpha is primarily a performance measure that shows whether an investment is outperforming or underperforming its benchmark.
The calculation is straightforward:
Alpha = Investment Return - Benchmark Return
Alpha is typically expressed as a decimal (e.g., 0.05 rather than 5%).
Example 1: Fund A returns 4% while its benchmark index returns 10%
Alpha = 4% - 10% = -6% (or -0.06)
Example 2: Fund B returns 15% while its benchmark index returns 10%
Alpha = 15% - 10% = +5% (or 0.05)
| Alpha Value | Interpretation |
|---|---|
| Positive (> 0) | The investment outperformed its benchmark |
| Zero (= 0) | The investment performed exactly in line with its benchmark |
| Negative (< 0) | The investment underperformed its benchmark |
Generating alpha is a primary goal for active portfolio managers who seek to justify their higher fees compared to passive index funds. However, studies show that most active managers fail to consistently generate positive alpha over time.
While alpha measures performance, beta measures volatility. These metrics are often used together:
An investment might offer attractive returns (high alpha) but with volatility (high beta) that exceeds an investor's risk tolerance.