Alpha
What is alpha?
Alpha is a key concept in financial theory that relates to the non-market
related return that a portfolio
manager earns. An easy way of thinking about it is as the return on a portfolio
less the expected return calculated using the CAPM.
In that way, it is basically the return on a portfolio after market risk and the
risk free return have been stripped out. Clearly this could lead to problems
using the metric if you were using the wrong market
return to compare, or using an inappropriate risk free rate, or if the beta
value had changed through time, etc. But aside from the potential problems, as
long as you calculate it consistently and with a sound basis, it will provide a
good gauge of how well the portfolio manager is doing at generating non-market
returns (i.e. it shows their skill at picking stocks/sectors/asset classes).
How does it relate to Markets?
As noted, alpha is an important performance metric in assessing stock picking
ability -i.e. the ability to generate returns independent of the market. Thus
generally one will want a manager that can consistently generate high alpha.
However if the money that is to be invested may be needed in the near term a
manger with a high alpha and a high beta would not be preferred because the high
beta implies a greater chance of losing money in a down market. So when
constructing your portfolio and planning your investments it is important to
understand the investment
options in the context of alpha and beta; which is a more detailed or
3-dimensional view of the risk-return trade-off.
Calculation
Below the calculation of alpha is outlined using the CAPM:
a= rp-[rf+Bp(rm-rf)]
a = Alpha
rp = Expected total portfolio return
rf = Risk free rate
Bp = Beta of the portfolio
rm = Expected market return
Sources and further reading:
Hedge Funds
Consistency Index - Alpha
Portfolio Analysis with Linear Regression
Investopedia - Alpha
iluka - The Tao of Alpha
Jensen, M. (1967) The Performance of Mutual Funds in the Period 1945-1964.
Journal of Finance, Vol. 23, No.2.
Graph Library:
n/a
Original Source:
http://www.econgrapher.com/encyclopedia-alpha.html
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