Alpha

By: admin

admin

What is alpha?
 

  • Alpha refers to the excess return on a stock portfolio or fund over and above the benchmark1.
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Alpha = Actual Portfolio Return – Benchmark Return
 

  • Generally, one generates alpha by actively managing a stock portfolio or fund with diversification, risk management.
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  • It is one way to measure stock portfolio or fund performance as it shows how much returns is generated by actively managing the stock portfolio or fund in comparison to benchmark returns.
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  • Positive alpha means stock portfolio or fund return has outperformed the benchmark return while negative alpha means underperformance of the stock portfolio or fund management.
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  • Suppose stock portfolio or fund return is 15% p.a. and benchmark return is 10% p.a. then we can say the stock portfolio or fund has generated positive alpha of 5% p.a.
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Jensen Alpha
 

  • Jensen alpha is another way to measure alpha by adjusting for the risk (beta2) taken.
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  • Jensen alpha formula is
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a = Rp – [Rf + (Rm –Rf) * ß

 
Where
a = Alpha
Rp = Portfolio return Rf = Risk free rate
Rm = Benchmark (Market) return
ß = Portfolio beta
 

  • From the above formula, we can see that there are 3 determinants of alpha – portfolio return, benchmark return and portfolio beta.
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  • Out of the three, portfolio beta can be actively managed by constructing a low or high beta portfolio as portfolio return is outcome of active management of portfolio beta and benchmark return cannot be controlled.
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  • Positive alpha is when portfolio return outperformed the benchmark return reflecting better risk adjusted portfolio.
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  • While negative alpha is when portfolio underperforms the benchmark reflecting portfolio has earned little for the risk taken.
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Link between alpha and beta
 

  • Alpha is the excess return one earns on a stock portfolio or fund vis a vis the benchmark returns.
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  • However, one should also measure the excess return generated against the risk taken for the investment.
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  • It is not correct to say stock portfolio or fund generated positive alpha unless it is adjusted for risk taken to invest.
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  • Let’s understand the link between alpha and beta with help of an example.
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  • Let’s assume a stock portfolio has a return of 14%p.a., beta of 1.5 and benchmark return of 12%p.a.
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  • We can see that without taking risk into consideration the stock portfolio has a positive alpha of 2%p.a. (14%-12%).
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  • Is this sufficient to say it’s a good investment without adjusting for the risk taken to invest?
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  • The portfolio has got beta of 1.5 which means its 50% more volatile than the benchmark. Therefore the portfolio should have earned a return of 18% p.a. (12% * 50%).
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  • However it has generated return of 14% p.a. i.e. 4% lower than the return required to compensate for the risk taken.
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  • Therefore, technically the portfolio has generated negative alpha of 4% which shows poor management skill or not a good investment even though portfolio return was higher than the benchmark return.
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  • Generally, investors prefer investing in stock portfolio or fund which has positive high alpha and low beta.
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