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The Alpha Alphabet

Dec 4, 2012 Marc Odo

One of the most frequently used terms in finance is “alpha”. Alpha is generally accepted as meaning “manager skill”. Certainly an important concept, it is unfortunate there are so many misconceptions about what alpha is and is not. Searching the web and old textbooks sometimes makes matters worse, as there many different definitions floating around.

The “The Alpha Alphabet” paper is meant to serve as a guide to all the different iterations and definitions of alpha. The strict definition of alpha is the portion of the manager’s returns that cannot be explained via a mathematical model. What makes the topic so complicated is there are many different mathematical models one can choose when analyzing an active manager’s returns, which will lead to different calculations of alpha.  Discussed in this paper are:

• Alpha in its simplest form
• Jensen’s alpha
• Factor models, like Fama-French and Carhart
• William Sharpe’s returns-based style analysis
• “Alternative beta” and hedge fund alpha
• Risk-normalization techniques like M2 and alpha-star

There is also a case study for which we ran the same fund through all the different variations of alpha and a discussion of what alpha is not. I trust this paper will provide you with a greater understanding of alpha. 

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