What is Alpha in Investing?

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What is Alpha?

Alpha (the Greek letter α) is a term used in investing to describe the ability of a strategy to demonstrate results above the average market, that is, for its competitive advantage.

Alpha is commonly used to rank active mutual funds, as well as all other types of investments.

It is often presented as a single number, (for example, +3.0 or -5.0), which is usually a percentage of how a portfolio or fund performed compared to a reference index (i.e., 3% better or 5% worse).

Excess return ” or “ Abnormal Rate of Return,

In addition, the alpha coefficient is also often called the excess return or abnormal rate of return. Due to the idea that markets are efficient. And therefore, there is no way to systematically make a profit above the average market.

Alpha and Beta

Alpha is often used in combination with beta (the Greek letter β). Which measures the overall volatility or risk of the market as a whole, known as systematic market risk.

Alpha can be positive or negative and is the result of active investing.

Beta gains, on the other hand, can be made through passive index investing.

Alpha and beta are used together by investment managers to calculate, compare and analyze profits.

Beta (or the beta coefficient) is used in CAPM theory. Where the expected return on an asset is calculated based on the beta of that asset and the expected return on the market as a whole.

Active Return on Investment

Alpha is often considered an active return on investment and shows the return on investment, in relation to a market index or benchmark that represents the movement of the market as a whole.

Alpha of the Investment

The excess return on an investment relative to the return on the underlying index is the alpha of the investment.

Alpha Jensen

A deeper analysis may also use alpha Jensen. Jensen’s Alpha takes into account the Capital Asset Pricing Model (CAPM) and includes a risk adjustment in the calculations.

Alpha parsing

Alpha is one of five popular technical risk factors.

Other such coefficients

Other such coefficients are beta, standard deviation, R-squared (coefficient of determination) and Sharpe ratio.

All these statistical indicators are used in modern portfolio theory (MPT).

All of these indicators are designed to assist investors in determining the risk profile and return on investment.

To eliminate unsystematic risks, active portfolio managers are trying to generate alpha in diversified portfolios and diversification.

Indicator of the Value

Since alpha shows portfolio performance compared to the benchmark. It is often considered an indicator of the value that the portfolio manager adds to or subtracts from the fund’s profits.

In other words, alpha is an investment return that is not the result of movements in a common market.

Zero Alpha Value

Thus, a zero alpha value will indicate that the portfolio or fund ideally follows the benchmark index and that the manager has not added or lost any additional value compared to the market as a whole.

Smart Beta

The alpha concept has become particularly popular with the advent of smart beta index funds linked to the Standard & Poor’s 500 and Wilshire 5000 Total Market Index.

These funds are trying to increase the productivity of the portfolio that tracks the target subgroup of the market.

Despite the obvious desirability of positive alpha in the portfolio, many indices manage to surpass the results of asset managers in the vast majority of cases.

 Robot Advisor

Partly due to the progressive lack of faith in traditional financial advisors caused by this trend, more and more investors are switching to low-cost passive online advisors (often called robot advisors). Who invest investors solely or almost exclusively in index funds, justifying this the fact that if it is impossible to defeat the market, the most reasonable solution is to join it.

Moreover, since most traditional financial advisors charge portfolio management fees, and zero alpha is actually a small net loss to the investor.

For example, suppose a financial adviser named Jim charges 1% of the portfolio value for his services, and that over a period of 12 months he was able to generate an alpha of 0.75 for the portfolio of one of his clients, Frank.

Although Jim actually increased Frank’s portfolio performance, but the fee he charges exceeds the alpha that he generated, so Frank’s portfolio suffers a net loss.

For investors, this example emphasizes the importance of focusing on fees combined with profitability and alpha.

Efficient Market Hypothesis (EMH)

The efficient market hypothesis (EMH) states that market prices take into account all available information at any time, and therefore securities are always priced correctly (the market is efficient).

Therefore, according to EMH, it is not possible to systematically identify and exploit pricing errors in the market because they do not exist.

If any errors in the estimates are detected, they are quickly eliminated through arbitration. Therefore, stable models of market anomalies that can be used are very rare and far from each other.

Empirical data comparing the historical profitability of active mutual funds with their passive benchmarks shows that in 10 years less than 10% of all active funds were able to earn positive alpha. This percentage becomes even lower if taxes and fees are taken into account.

In other words, the alpha value is hard to find, especially after taxes and fees.

Since beta risk can be isolated by diversifying and hedging various risks (with different transaction costs), some people assume that there are actually no alpha profits. They simply constitute compensation for taking an unhedged risk that could not be identified, or But he was lost.

Calculation of Alpha Investment Value

The investment sector offers investors a wide range of securities, investment products and advisory opportunities.

Different market cycles also affect alpha investment performance in various asset classes.

It is therefore the poet, in combination with alpha, for analysis it is important to use indicators of risk and profit.

Capital Assets Pricing Model (CAPM)

The CAPM is used to calculate the amount of return that investors need to realize to compensate for a particular level of risk. It subtracts the risk-free rate from the expected rate and weighs it with a factor-beta to get the risk premium. It then adds the risk premium to the risk-free rate of return to get the rate of return an investor expects as compensation for the risk. The CAPM formula is expressed as follows:

r = Rf + beta (Rm – Rf) + Alpha

How to Calculate Alpha?

Formula for calculating Alpha Value:

Alpha= R – Rf – beta (Rm-Rf)

Where

  • R represents the portfolio return
  • Rf represents the risk-free rate of return
  • Beta represents the systemic risk of a portfolio.
  • Rm represents the market return

For example, assuming that the actual return of the fund is 30, the risk-free rate is 8%, beta is 1.1, and the benchmark index return is 20%, alpha is calculated as:

Alpha = (0.30-0.08) – 1.1 (0.20-0.08) = 0. 088 or 8.8%

The result shows that the investment in this example outperformed the benchmark index by 8.8%

Explanation of Alpha Formula

The formula for alpha can be derived by using the following steps:

  1. Step 1

    Firstly, determine the risk-free rate of return for the case. Typically, the annual yield of government bonds or treasury bills are considered to be risk-free and as such is used as the risk-free rate of return.

  2. Step 2

    Next, determine the market return and usually, the return of the major stock market index is taken as the proxy for market return. For instance, the annual return of S&P500 can be used as the market return. Now, calculate the market risk premium by subtracting the risk-free rate from the market return.

    Market Risk Premium = Market Return – Risk-Free Rate

  3. Step 3

    Next, determine the beta of each security based on their relative price movement as compared to the benchmark index. Then, calculate the beta of the portfolio using a weighted average of all the securities. The portfolio beta is denoted by β.

  4. Step 4

    Next, calculate the expected rate of return by using risk-free rate (step 1), market risk premium (step 2) and portfolio beta (step 3) as shown below.

    Expected Rate of Return = Risk-Free Rate of Return + β * Market Risk Premium

  5. Step 5

    Next, determine the actual rate of return of the portfolio.

  6. Step 6

    Finally, the formula for alpha can be derived by subtracting the expected rate of return of the portfolio (step 4) from its actual rate of return (step 5) as shown below.

    Alpha = Actual Rate of Return – Expected Rate of Return

    Alpha = Actual Rate of Return – Risk-Free Rate of Return – β * Market Risk Premium

This is illustrated in the following two real-world examples for fixed income ETFs and stock-based ETFs

iShares Convertible Bond ETF ( ICVT )

iShares Convertible Bond ETF ( ICVT ) is a fixed-income, low-risk investment.

It tracks a branded index called Bloomberg Barclays US Convertible Cash Pay Bond> $ 250MM.

ICVT average annual standard deviation was relatively low at 4.72%.

From the beginning of the year to November 15, 2017, its profitability amounted to 13.17%. The growth rate of the Bloomberg Barclays US Aggregate Index for the same period amounted to 3.06%.

Thus, the alpha for ICVT compared to the Bloomberg Barclays US Aggregate Index was 10.11% at relatively low risk with a standard deviation of 4.72%

However, since the aggregate bond index is not a suitable benchmark for ICVT (it should be the Bloomberg Barclay Convertible Index), alpha may not be as large as originally intended.

In fact, its meaning may turn out to be wrong, since convertible bonds have much more risky profiles than ordinary bonds.

WisdomTree US Quality Dividend Growth Fund ( DGRW )

WisdomTree US Quality Dividend Growth Fund ( DGRW ) is a fund that invests in stocks with increased market risk, which invests in stocks of companies focused on dividend growth.

His portfolio tracks a specially crafted index called the Wisdomtree US Quality Dividend Growth Index.

It has an annual standard deviation of 10.58% for three years, which is higher than that of ICVT.

Its return from the beginning of the year to November 15, 2017 is 18.24%, which is 14.67% higher than the S&P 500, so the fund has an alpha of 3.57% in relation to the S&P 500.

But, again, the S&P 500 is not the right benchmark for this ETF, since the shares of growing companies paying dividends are a very specific subset of the general stock market and many of them are not on the list of the 500 most valuable shares in the United States.

The above example illustrates the success of two fund managers in creating alpha profits.

However, the available data indicate that the performance of active managers in achieving profits such as alpha in funds and portfolios throughout the investment sphere is not always so successful.

Statistics show that over the past ten years, 83% of active funds in the United States lag behind their chosen benchmarks.

Experts attribute this trend to a variety of reasons, including

  1. The growing experience of financial advisors.
  2. Advances in financial technology and software, which are at the disposal of consultants.
  3. Expanding the potential of potential investors to participate in the market due to the growth of the Internet.
  4. Reducing the proportion of investors taking risk in their portfolios.
  5. The increase in the amount of money invested in the possibility of making a profit such as alpha.

Alpha Considerations

Although alpha is called the ” holy grail ” of investment, and therefore it receives a lot of attention from both investors and consultants, some important considerations should be taken into account when using it

Namely

  1. In the basic calculation of alpha, the total return on investment is subtracted from the benchmark in the same asset category. This calculation is mainly used only for comparison with benchmarks from the same asset category, as noted in the examples above. Thus, it does not measure the performance of stock ETFs compared to a benchmark in the fixed income category. This alpha is best used when comparing the performance of similar asset investments. Therefore, the alpha of the joint-stock ETF DGRW is not comparable with the alpha of the ETF of the fixed income category ICVT.
  2. Some references to alpha may relate to a more advanced method. Jensen’s alpha is calculated based on the CAPM theory and risk adjustment measures using the risk-free rate and beta.

When using the generated alpha value, it is important to understand all the relevant calculations.

The alpha value can be calculated using different index benchmarks from the same asset class.

In some cases, there is no suitable existing index, and then financial advisers can use various algorithms and models to simulate the index specifically for calculating the alpha value.

The term alpha may also refer to an abnormal rate of return on a security or portfolio that exceeds the values ​​predicted by models such as CAPM.

In this case, the CAPM model can be aimed at assessing the profit received by investors at various points along the boundary of efficiency.

A CAPM analysis can show that a portfolio in its risk profile should earn 10%.

If the portfolio actually earns 15%, the portfolio alpha will be 5.0 or + 5% compared to the forecast of the CAPM model.

Alpha Related Terms

Alpha Generator

An alpha generator is a security that, when added to an existing portfolio, generates excess returns or returns above the benchmark without additional risks.

Jensen’s Measure

The Jensen or Alpha Jensen indicator measures that part of the results of the work of the investment manager that is not related to the movements of the market as a whole.

Excess Returns

Excess return, also known as the alpha coefficient, is the percentage by which the fund manager outperforms the risk-free security.

Risk Measures

Risk indicators give investors an idea of ​​the volatility of the fund relative to the underlying index.

Abnormal profits, both positive and negative, differ from expected profits

Abnormal profit is the profit on a security or portfolio for a certain period, which differs from the expected profit for the same period.

Benchmark

The benchmark is the standard by which you can measure the performance of a security, mutual fund or investment manager.

Question Answer

What is Alpha in CAPM equation?

Mathematically speaking, alpha is the rate of return that exceeds what was expected or predicted by models like the capital asset pricing model (CAPM).

What is Alpha Investment?

In essence, Alpha Investment is a mutual fund. That is, you need to purchase a certain number of shares in order to start earning.

What is alpha strategy?

Alpha arbitrage, also known as alpha strategy, refers to the reverse hedging of index futures and securities products with alpha values, that is, long securities products with alpha values, short index futures, to achieve market evasion under systemic risks Alpha return of the index. In order to achieve alpha arbitrage, the selection or construction of securities products is the key.

What is the Alpha risk?

The risk in the statistical test is that the null hypothesis will be rejected when this is true. This is also known as type I error. The best way to reduce alpha risk is to increase the size of the test sample, hoping that a larger sample will be more representative of the population.

What is alpha generator?

An alpha generator is a security that, when added to an existing portfolio, generates excess returns or returns above the benchmark without additional risks.

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