Alpha

In plain words

Positive alpha means the manager did better than their level of risk alone would have predicted.

In more detail

Alpha is the return beyond what the risks taken can explain. The decisive question is therefore always: measured against which model? A manager with 5 percent alpha against the market index can have zero alpha against a multi-factor model, if his excess return comes entirely from size and value exposure. Genuine alpha is rare, hard to demonstrate and harder still to sustain — most apparent alphas are unrecognised factors.

Formula

Alpha = Actual return − Expected return (from a risk model, e.g. CAPM)

Compares the return actually achieved with the return a risk model (e.g. CAPM) would have expected for the risk taken.

Example

A fund reports 4.2 percent alpha against the market index. After accounting for size, value and momentum, 0.3 percent remains — against a 1.4 percent fee.

What it means for traders

A central metric for assessing the value added by active fund management.

Common pitfalls

Historical alpha is no guarantee of future outperformance and can arise by chance.

Related terms

Abnormal Return · Active Management · Active Return · Alpha Factor · Attribution Analysis · Benchmark · Beta · Excess Return · Sharpe Ratio