Tune into any financial media network and you’re sure to hear about fund managers and investment strategists talking about alpha. But what is alpha, and why is everyone talking about it? It certainly has no relation to alpha dogs.
Alpha in Investing
Financial market returns can be split into two categories. First, there’s alpha, which is the subject of this article, and then there is beta. Here’s a quick layman explanation for both:
- Alpha – Alpha is a measure of returns after risk is considered. Risk is defined as beta, which is the next term to define.
- Beta – Beta is a statistical correlation between an investment and the broad market. Beta is a measure of how volatile one investment is compared to the volatility of the S&P 500 index.
When investors look at potential investments, particularly funds, they consider beta and also the fund manager’s ability to generate alpha. For example, a fund that is just as volatile as the S&P 500 index has a beta of 1. To generate alpha, a fund manager would have to generate a return greater than the S&P 500 index.
Consider this: a mutual fund returns 11% in a single year. The mutual fund has a beta of 1, meaning that it was just as volatile in its up and down swings as the S&P 500 index. If the S&P 500 index returns only 10%, then the mutual fund manager is said to have generated alpha returns.
On a risk-adjusted basis (the mutual fund and the S&P 500 were equally volatile, so they have the same risk) the fund manager produced better returns than one would expect. The mutual fund manager generated alpha.
Alpha in Practice
Investors use alpha as a way to distinguish between investment managers who outperform the market by accepting more risk, and investors who beat the market when risk is considered. It would not be fair to praise an investment manager who beats the market because he or she takes on more risk.
As everyone knows, risk and reward share a direct relationship. As risk goes up, so does the potential reward. Likewise, when risks are limited, the rewards are also capped.
Hedge funds make extreme use of the concept of alpha and beta. Many hedge funds seek to generate returns regardless of what the market does. For example, a hedge fund might be hedged entirely, investing 50% of its capital in long positions and 50% of its capital in short positions. In an ideal world, the hedge fund would have a beta of 0, since any up day in the market will increase the value of its long positions, and decrease the value of its short positions.
Generating a positive return with a fund that has a beta of zero can only be done if the portfolio manager is highly-skilled. A rockstar return for a hedge fund manager with a beta of zero would be just a few percentage points per year. This is a stellar return because of the very low risk of the fund – it is not at all correlated to the market, and therefore its capital gains or losses don’t come from risk, but from intelligent investment selection.
A fund with a beta of 0 would be extremely safe as a leveraged investment. Hedge funds that can generate position returns with zero correlation to the market are preferred among big investors. If you can borrow money at 1% to invest with a skilled fund manager who can give you 5% per year with no correlation to the market, you can make obscene amounts of money with virtually no risk to your investment capital.