Alpha, stylized as the Greek letter α, is the excess return generated by an investment strategy. When compared with an underlying market index the excess performance of that investment is calculated. Alpha is commonly used to judge the performance of manager skill and what value is being added to the active fund management strategy. Should a given manager underperform the market, it is possible that they generate a negative alpha. In this case, investors would have been better off making an investment in the underlying index fund. A simple ETF index fund investment with sufficient diversification would have avoided the fee expense and the negative performance.
The combination of alpha and beta make up the return of a given investment strategy. That is, the part attributed to manager skill and the remaining part that is attributed to broader market movements.
How Alpha is Used in the Real World
By using the capital asset pricing model (CAPM), it is possible to analyze a portfolio of investments and calculate its theoretical performance. Once the actual returns on that portfolio are observed in the market, they can be compared with the theoretical returns. This measure is known as Jensen’s alpha. This is useful for non-traditional or highly focused funds such as merger arbitrage or other event driven investment strategies. Merger arbitrage is an investment strategy that has a number or variants operating under the same moniker and as such is difficult to define from one fund manager to another. In these instances, a single stock index or base case scenario is probably not representative of the funds investment approach. Private equity funds are another example of the difficulties in assessing performance.
Merger arbitrage investing can generate alpha by using the skill of the manager to avoid deal may not consummate successfully. However, this return may be masked by broader market movements as despite the takeover being the dominant factor moving the stock price, the target firm is still susceptible to broader economic influences, also known as beta.
Despite the insistence of fund managers that alpha is achievable and sustainable there are sections of the market that refute this claim. The Efficient Market Hypothesis (EMH) postulates that market prices incorporate all available information at all times. Therefore, securities are always correctly priced as the market is efficient. If mispricing’s are identified, they are quickly arbitraged away so that persistent patterns of market anomalies cannot continuously taken advantage of. Should this argument hold, alpha would be unachievable over an extended period of time.
