Alpha

Alpha is the difference between a fund's expected returns based on its beta and its actual returns. Alpha is sometimes called the value that a portfolio manager adds to the performance. If a fund returns more than what investor had expected given its beta, it has a positive alpha. If a fund returns less than its beta predicts, it has a negative alpha. Beta tells you how much you can expect a fund's returns to move up or down given a movement of its benchmark. For example, if the ABC Fund has a beta of 1.1 in comparison with the S&P 500 and the S&P 500 returns 30% for the year, you would expect ABC Fund to return 33%. (30% x 1.1 = 33%.)

Since mutual funds don't necessarily produce the returns predicted by their betas, alpha can be helpful to investors. To calculate a fund's alpha, first subtract the return of the 90-day Treasury bill from the fund's raw return (the idea being that the return of a mutual fund should, at the very least, exceed that of a risk-free investment). That gives you a fund's excess return. From that, subtract the fund's expected return based on its beta. What's left over is the alpha. Because a fund's return and its risk both contribute to its alpha, two funds with the same returns could have different alphas. Further, if a fund has a high beta, it's quite possible for it to have a negative alpha. That's because the higher a fund's risk level (beta), the greater the returns it must generate in order to produce a high alpha.

Alpha is to measure the extra return rewarded to investor for taking on risk posed by factors other than market volatility. Alpha measures how much if any of this extra risk helped the fund outperform its corresponding benchmark. It looks at the relationship between a fund's historical beta and its current performance, or the difference between the return beta would lead you to expect and the return a fund actually gets. An alpha of 0 simply means that the fund did as well as expected, considering the risks it took, So if that fund with the beta of 1.15 beat the market by 15% (or underperformed it by 15% when the market was down), it would have a 0 alpha. If your fund has a positive alpha, which means it returned more than its beta predicted. A negative alpha means it returned less. The trouble with alpha is that it's only as good as its beta. If the benchmark isn't appropriate to a fund in deriving its beta, then alpha, too, will be imprecise.

Alpha was designed to take beta one step further. As compare to beta, alpha's computation compares the fund's performance to that of the benchmark's risk-adjusted returns and establishes if the fund's returns outperformed the market's, given the same amount of risk.

High-alpha funds are delivering returns higher than they should be, given the amount of risk they assume. But alpha has its quirks. For starters, because alpha measures performance relative to beta, any drawbacks that apply to beta also apply to alpha. If a fund's beta isn't meaningful because its R-squared is too low (below 75), its alpha isn't valid, either. Secondly, alpha fails to distinguish between underperformance caused by incompetence and underperformance caused by fees. For example, because managers of index funds don't select stocks, they don't add or subtract much value. Thus, in theory, index funds should carry alphas of zero. Yet many index funds have negative alphas. Here, alpha merely reflects the drag of the fund's expenses. Finally, it's impossible to judge whether alpha reflects managerial skill or just plain old luck. A positive alpha today may turn into a negative alpha tomorrow.