How it works
Alpha is measured against a benchmark. In the most common version, called Jensen's alpha, you first work out the return you would expect given the investment's beta, using CAPM. You then subtract that expected return from the actual return. What is left is alpha.
Fund managers present alpha as evidence of skill. Many investors treat it with caution, because past alpha often does not repeat, and because fees reduce what the investor actually keeps.
Alpha = Actual return − [Risk-free rate + Beta × (Market return − Risk-free rate)]
A simple example
How it is used
- Judging whether a fund manager added value beyond simply taking market risk.
- Comparing funds that take different amounts of risk.
- Separating skill from luck, over long periods.
Common mistakes
- Judging alpha from a short period. Luck can look like skill.
- Using the wrong benchmark.
- Ignoring fees.
- Assuming positive past alpha will continue.
Questions
What is the difference between alpha and beta?
Beta shows how much an investment moves with the market. Alpha shows the return left over after allowing for that market risk. Beta is exposure to the market. Alpha is out-performance or under-performance.
Is alpha the same as excess return?
Not exactly. Excess return is the return above the risk-free rate or a benchmark. Alpha also adjusts for the investment's beta.
Keep learning
- What is beta in finance?
- What is the Sharpe ratio?
- What is CAPM and the cost of equity?
- Damodaran: historical returns on stocks, bonds and real estate
- Glossary: Alpha
- Glossary: Beta
- Glossary: Capital asset pricing model (CAPM)
- Glossary: Sharpe ratio