What is Alpha?

Alpha is like the yellow jersey in the Tour de France...

In the Tour de France, some jersey colors tell you about the racers. The most coveted is the maillot jaune, or yellow jersey, because it indicates who’s ahead in the race at that point. Likewise, alpha is a measure that tells you about the performance of an investment in relation to its “peers.”

Alpha measures the performance of an investment compared with a benchmark over a period of time. Comparing the return of an investment to a benchmark helps investors assess the potential excess return it can create.

The S&P 500, a financial index that tracks the performance of 500 large American companies, is a common benchmark for the stock market as a whole. An investor who wants to “beat the market” tries to find investments that can outperform this index.

Alpha is a way to quantify whether an investment can do so with a single number. For example, an alpha of +3 indicates that a portfolio beat the return of the S&P 500 index by 3 percent over a certain period of time.

Since alpha measures the ability of an investment to do better than the market using historical data, it’s important to remember that past performance doesn’t guarantee future results.

Alpha and beta are both ratios that compare the performance of a stock against that of the market as a whole, but they do so in different ways.

Alpha focuses on the additional return that an investment provides on top of the market’s return. Beta indicates the volatility of a stock’s price relative to the market, as well as whether it moves in the same direction as the market as a whole. For example:

• An alpha of +2 means the return of an investment beats the return of the selected benchmark by 2 percent.
• A beta of +2 signals that an investment is twice as volatile as the market. So if the market goes up by 5 percent, the stock should go up by 10 percent. If the market declines by 3 percent, the stock price should drop by 6 percent.

A beta of 1 indicates that a stock is as volatile as the market and that its price correlates strongly with the market. When beta is higher than 1, the investment is more volatile than the market. A beta higher than 0 and less than 1 means the investment is less volatile than the market.

When beta is 0, the investment and the market have no correlation. When beta is negative, the investment is inversely correlated with the market, meaning it tends to go up when the market goes down, and vice versa.

Alpha can be negative, positive, or even zero.

Positive alpha means that the investment’s return was above that of the benchmark (e.g., +1 or 1 percent above market return). Negative alpha signals that the investment’s performance was below that of the market (e.g., -0.5 or 0.5 percent below market return). An alpha of 0 indicates that the investment’s return matched that of the market, based on the benchmark used.

There are several ways to calculate alpha.

Calculating alpha the straightforward way

The simplest way to calculate alpha is to subtract the total return of an investment from a benchmark in the same investment category. For example, let’s assume that throughout 2019, you held an investment in an all-equity portfolio that provided a return of 30 percent. During the same period, assume the S&P 500 produced a return of about 28 percent. By subtracting the S&P 500’s return from that of your investment, you find that your portfolio’s alpha was +2 (30 - 28).

Calculating alpha using the CAPM

A more comprehensive way to calculate alpha is through the capital assets pricing model (CAPM), a model that calculates the expected return of a security given its risk. This formula uses beta and the risk-free rate — a rate of return that an investor can expect assuming zero risk (e.g., the three-month US Treasury bill).

The formula is:

R represents the investment’s return Rf represents the risk-free rate of return Beta represents the systemic risk of any investment Rm represents the benchmark return

Let’s assume that a portfolio’s return is 10 percent, the risk-free rate is 6 percent, the investment’s beta is 1.1, and the benchmark return is 9 percent. Using the CAPM, you calculate alpha as follows:

Alpha = (0.10 - 0.06) - 1.1 (0.09 - 0.06) = +0.007

The formula shows that this portfolio outperformed the benchmark index by 0.007 percent.

How to calculate alpha using the CAPM in Excel

Starting on cell A1, set up two columns: one to describe the variable and one for the value. Using the values from the previous example, you would set up a spreadsheet like this:

Format the values for cells B1, B2, B4, and B5 as percentages, and the value for cell B3 as a general number.

In cell B5, input the following formula:

This formula would calculate the values that you wrote in column B or (0.10 - 0.06) - 1.1 (0.09 - 0.06). In this scenario, the resulting alpha of the investment is +0.007; this portfolio outperformed the benchmark index by 0.007 percent.

A good alpha is in the eye of the beholder. One could argue that any positive alpha is “good” because it indicates an investment outperformed the market. However, an alpha that is very high often comes with greater risks. In investing, the level of potential risks and rewards is highly correlated.

Choosing an investment or asset class depends on many other factors, including your risk tolerance (how much risk you can handle) and your time horizon (how long before you need the money you’re investing).

“Seeking alpha” is a mantra of some investment and hedge fund managers.

Alpha strategies are active investment strategies that focus on choosing investments that have the potential to beat the market. Instead of passively investing in index funds that mimic market movements, investors using alpha strategies research, develop, and execute strategies that have a high alpha.

Of course, higher potential returns also come with higher risks. Ideally, investors using alpha strategies also take steps to manage risks and limit potential losses.

Historically, few active investors can consistently beat the market. According to a Morningstar study, just 23 percent of all actively managed funds beat the average return performance of passive ones over a 10-year period. Alpha is a measure of past performance, which is no guarantee of future results.

The alpha of any stock varies depending on which calculation formula you use and which benchmark you select. Alpha also changes over time, so it should be assessed periodically.

When using alpha to compare investments, you may want to keep in mind a couple of best practices:

• Important Caveat: While it's possible to calculate alpha with other asset classes, alpha is best suited for stocks.
• Evaluate similar funds: Make apples-to-apples comparisons. For example, a fund focusing on real estate companies isn’t the same as a fund focusing on mid-cap companies.
• Use the same benchmark to compare different investments: Comparing a fund with an alpha based on the S&P 500 against a fund with an alpha based on the Russell 2000 is not appropriate.
• Determine the right benchmark: The S&P 500 is the most common benchmark. Sometimes, another fund is more relevant, such as the NASDAQ-100 Technology Sector Index for tech stocks and the Dow Jones Industrial Average for blue-chip stocks.
• Remember alpha isn’t a crystal ball: Alpha is calculated using past performance, so it’s just an estimate. It’s no guarantee of what will happen in the future.