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Expecting the unexpected

Lesson in Course: Portfolio management (advanced, 6min)

I've heard some investors talk about alpha, but what is it?

Eureka!

What it's about: Alpha is the measurement of our investments compared to the market.

Why it's important: Alpha lets us know if the decisions we are making are working.

Key takeaway: An alpha of 0 means our decisions are as good as the average investor. Positive alpha means we have a competitive edge.

As we are starting to invest more, how do we know if we are successful? It's a question everyone asks themselves and success is all relative for the individual. However, within the investment industry, success is categorically defined as how well our investments grow compared to everyone else. 

When we make an investment decision, we have some idea of what we expect to receive as a return on that investment over a given period of time. While there are many ways we can come up with the expected return, the actual return over that time is usually different. The difference between the expected return and the actual is our alpha.

What is Alpha?

Alpha measures the excess return on a risk-adjusted basis. Alpha = Return of investment - Return of benchmark

If we've picked our investments exceptionally well, we should have a positive alpha. Professional active investors prioritize tracking their alpha because it serves as feedback for their strategies and their ability to beat the average investor. If the average investor is considered the market, then the market return is chosen as the benchmark to beat.

Alpha means we are making more money than others

Alpha represents the performance that we weren’t expecting to get relative to the risks that we took. In practice, alpha is the outperformance or underperformance relative to some benchmark or index. An investment has a positive alpha if it has a higher return than its benchmark and a negative alpha if the return is lower than the benchmark.

 

How alpha is used in practice

Portfolio managers hired by mutual funds charge everyday investors a fee for their services. If we are paying mutual funds a fee, then we need to know they can do better than we can with a simple ETF. Alpha can be used to evaluate the performance of a mutual fund relative to a benchmark index. For a fund that invests broadly in US stocks, its alpha might be based on comparing its return to the S&P 500. Let's look at an example of $VTSAX, a Total Market mutual fund by Vanguard.

VTSAX alpha

We can see the benchmark used is the S&P 500 and the fund is has a negative alpha. This means that the money managers charged money to be worse than a SPY ETF.

Alpha is often used to justify higher fees on some mutual funds with the implication being that we’re paying for the additional returns attributable to the fund manager’s skill; however, most index benchmarks actually beat asset managers a vast majority of the time like what we saw in our example above.

Generating consistent alpha is quite difficult

Alpha is also used to compare stock performance relative to an index of the sector or industry that it is in. This allows us to quickly see how the stocks we own have been doing relative to their peers. Let's look at an example with $TSLA.

TSLA alpha

TSLA has an alpha of 0.65 compared to the Dow Jones index. This means TSLA returns 65% more on average compared to the market represented by the DJI.

Applying alpha

We can use alpha to monitor how our investments are doing or we can use alpha to pick future investments. While doing so, we should only compare apples to apples. So the alpha of a stock or a fund needs to be compared to a benchmark or index that has similar risks. It wouldn’t make sense to determine the alpha of a stock by calculating its return and comparing it to a bond index. Stocks are much riskier than bonds so we would expect them to have higher returns.

Investments with periods of negative alpha should be reconsidered

Secondly, when deciding which investment to buy or sell, we should only compare the alpha if those investments have similar risks. As in, we can’t compare the alpha of a mutual fund that invests in stocks with the alpha of a mutual fund that invests in bonds—alpha would always steer us towards riskier bets.

Actionable ideas

Capturing alpha requires active investing but it can also be a buy or sell signal. We can use alpha as a tool to evaluate the performance of our investments relative to our expected return. If we have stocks or funds that have a large positive or negative alpha, we’ll want to look into some news about the company to find out why it’s outperforming or underperforming. Depending on the news, it could be time to cash in or cut our losses if we don't expect things to continue to improve or turn around.

There is no guarantee that an investment will produce alpha so, for most investors, a low-cost index-tracking ETF is often a better choice.

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Glossary

What is Alpha?

Alpha measures the excess return on a risk-adjusted basis. Alpha = Return of investment - Return of benchmark