Alpha is a financial tool indicating an investment’s performance relative to its benchmark index in the market.
What Is Alpha?
Alpha is a risk ratio that analyzes how well an investment has been doing in comparison to a market index. A positive alpha indicates that an investment is doing better than the benchmark, while a negative alpha is a sign the fund is underperforming. If alpha is zero, it is deduced that it is aligned perfectly with the benchmark
. It is one of the five risk ratios that help investors measure the risk of any investment.
Alpha is an indicator of historical performance; it does not predict the future. It is based on earnings-per-share growth. S&P 500
is an index tracking the top 500 companies of the US and can be used as a benchmark for calculating your alpha.
When it comes to mutual funds, an alpha is determined by calculating the excess return from the weighted average of stocks in a fund. It is just another tool that helps investors evaluate the risk/reward by using data from previous similar investments. In the long run, several funds generate returns that are much higher than market indexes. Investors have to consider how much risk they are willing to take to receive rewards, and one way to measure risk is via alpha.
How Does Alpha Work With Beta?
Although alpha independently gives valuable information, to get the full picture, investors need to take beta into account as well. Two different funds can have similar returns but have different alphas to different betas. Most investors prefer a fund with high alpha and low beta since it means that it has market-bearing returns with low risk and volatility. However, aggressive investors sometimes appreciate higher beta since their investment strategy is based on volatility.
Most conservative investors often avoid funds with high alpha and high beta. For instance, if they are near retirement and know they need access to their funds, they will not want to go where there is high volatility.
What Metrics Are Used to Calculate Returns?
Alpha and beta form a pricing aspect called the capital asset pricing model. It is a part of a financial theory known as the Modern Portfolio Theory
(MPT). The goal of MPT is to identify and assemble a diverse range of investments to outperform or maximize market returns while taking minimal risk.
For an index active approach, an investor not only needs to calculate alpha and beta but also pay importance to Correlation, Standard Deviation and R-squared indices. Correlation is an estimate of the strength and direction of a fund. Standard deviation measures the variability of a fund’s returns over time while R-squared calculates the relationship between the movement in investment and its benchmark. These five along with other financial metrics that give an approximate are extremely valuable for an investor.