Alpha is often described as a measure of a manager’s skill, or ability to add value over a passive benchmark. It is important to remember that alpha first adjusts for the degree of market risk undertaken by the manager. Alpha is what remains after the market risk, or beta, is netted out.
One would want to see a positive value for alpha, and the higher the better. Positive alpha indicates that after adjusting for market or “systematic” risk, the manager was able to outperform a passive benchmark. Alpha can be generated by superior security selection, over/underweighting sectors, market timing, or any variety of factors. A positive alpha indicates that those active management decisions paid off.
It is entirely possible that a manager could outperform the benchmark and have negative alpha. If the manager undertook excess risks and only generated marginal outperformance versus the benchmark, the manager could exhibit negative alpha.
Alpha measures returns relative to a market benchmark. A manager can have a respectable alpha (e.g. an alpha of +3.5), but the overall returns of the manager could be negative if the benchmark itself had negative performance.
Below are two managers: an aggressive manager in red and a conservative manager in blue. Looking only at excess return over the benchmark, the aggressive manager looks preferable to the conservative manager. However, the key to the calculation of alpha is the amount of beta-risk the manager has undertaken. In the graph below, the aggressive manager’s beta (1.4) is double that of the conservative manager’s beta (0.7).
Because the aggressive manager took on so much risk, the excess return should be much higher. The negative alpha indicates that the aggressive manager was not adequately compensated for the high level of risk. The conservative manager was able to outperform the benchmark while maintaining a lower level of risk, resulting in a positive alpha.
The table below displays the ranges of 10-year alphas across six asset classes. Peer groups of separately managed account composites are compared to their relevant benchmarks. The data here suggests that the median manager typically has an alpha near zero. Some funds do better than the benchmark and some worse, but the distribution is centered around zero. The range of alphas is widest in small cap US stocks and international stocks, which are often perceived as more inefficient asset classes where active managers tend to take larger bets.
The simpler, standard definition of alpha is to treat a manager’s total returns as a combination of two components: a portion that is a function of market movements and a portion that is unique to the individual manager. Rearranging the terms, alpha can be expressed as:
Another common version of alpha is known as Jensen’s alpha or cash-adjusted alpha. This version first subtracts out a risk-free rate from both the manager returns and the benchmark returns before proceeding with the standard alpha calculation. Jensen’s alpha is more in-sync with the Capital Asset Pricing Model (CAPM). It is written:
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