What is alpha and the secret to investment outperformance?

Alpha is a term that is loosely described as a measure of outperformance. Alpha is a highly discussed topic among fund managers as they are always seeking to outperform markets and generate alpha returns on their funds. If a portfolio manager can generate alpha in a bad year or a low-growth business cycle, you should know that you can trust him. 

So let’s delve deep into what is alpha, its computations and the strategies one can adopt to generate it. 

What is alpha in the stock market?

Alpha, also known as “alpha return” or simply “excess return”, is a financial metric that evaluates an investment’s performance compared to a benchmark index. It gauges the extent to which an investment has outperformed the market. 

You may also like: Understanding the P/E ratio

How do you interpret alpha returns in the stock market?

Alpha is an important metric for investors because it also helps to check the skills and performance of fund managers. Read on, to find out about the significant factors that affect alpha:

Skill vs luck

Alpha permits investors to distinguish between skill and luck when evaluating investment performance. A positive alpha means that the fund manager has outperformed the market, meaning that his skills actually helped him to outperform the market.

Performance evaluation

Alpha provides a more nuanced view of investment performance compared to simple returns. Investors can use it to evaluate whether a fund or portfolio manager’s strategies are effective in generating excess returns.

Benchmark comparison

Alpha enables investors to figure out how well an investment has performed compared to a benchmark like the Nifty 50 or Sensex. It offers insights into whether the portfolio strategy has beaten the market or fallen short of expectations.

Investment decision-making

Investors can use alpha to make informed investment decisions. Positive alpha may indicate that an investment is worth considering, while negative alpha may signal the need for a closer look at the investment strategy.

How to calculate alpha?

The formula for CAPM is:

E(Re) = Rf + (Rm-Rf)* β

E(Re)is the expected return on investment. Since alpha is the extra return that is earned over and above the expected return, alpha’s formula is:

Alpha = Actual Return – E(Re)

Let’s break down the components of the alpha return formula:

1. Actual return: This is the actual return generated by the investment during a specific period.
2. Risk-free rate (Rf): This is the minimum return you are likely to earn by investing in the safest government bond. This does not involve any risks.
3. Beta (β): Beta is the stock’s sensitivity to the market. It quantifies how much the investment’s returns are expected to move about the benchmark index.
4. Market return: This is the return earned from the benchmark index over the same period as the investment.

Let us understand this with an example:

Suppose an investment generates a return of 12% over a year, the risk-free rate is 2%, the market return is 10%, and the investment has a beta of 1.2.

Alpha = 12% – [2% + (1.2 * (10% – 2%))]

= 12% – [2% + (1.2 * 8%)] = 12% – [2% + 9.6%]

= 12% – 11.6%

Alpha return = 0.4%

In this example, the investment has a positive alpha of 0.4%, indicating that it outperformed the market by 0.4% after adjusting for its level of risk (as measured by beta).

Also read: Beat the market: Your ultimate guide for fundamental analysis tools.

How can a fund manager generate alpha in trading?

Now that we understand what alpha is and how it is calculated, let us explore a few basic strategies for attaining alpha in the stock market:

Active portfolio management

Skilled fund managers and investors actively select stocks or other assets they believe will outperform the market. It involves in-depth research of the assets where the fund manager wishes to put his money. 

Factor-based investing

Portfolio managers use models like the Fama & French model where factor-based investing is done. It involves targeting factors like value, growth, quality or momentum to drive excess returns.

Market timing

Timing the market by identifying favourable entry and exit points can lead to alpha generation. However, market timing is difficult and risky, as it requires accuracy in predicting the market movements.

Arbitrage strategies

These opportunities arise when there are differences in the price of the same assets in other markets. Portfolio managers quickly identify these opportunities and execute the buy-sell orders simultaneously to benefit from these price differences.

Alternative investments

Alternative assets like private equity, hedge funds or real estate offer avenues for alpha. These assets allow investors to diversify their portfolios and capture alpha. 

Also read: The market value effect – how can it make or break your investments?

Conclusion 

Alpha is a fundamental concept in stock market investing. Understanding alpha in the market is essential for checking the skills of a portfolio manager. While alpha offers the potential for outperformance, it comes with challenges. Investors should carefully consider their investment goals, risk tolerance, and time horizon when seeking alpha. It is ideal to combine alpha-seeking strategies with passive index investing for a well-rounded portfolio.