Alpha
What is alpha and why does it matter?
Quick Definition
Alpha is one of the most basic and fundamental performance metrics relating to a strategy or private fund. In short, alpha measures the returns of a strategy against a target benchmark. Thus, positive alpha is directionally good, and negative alpha is directionally bad. However, basic alpha does not incorporate any consideration toward risk or volatility, is in of itself unlikely to paint a useful picture of a fund or its strategy, and is generally considered alongside other performance metrics
Calculating alpha
Alpha can be simply calculated as [(absolute returns of strategy over period) – (absolute returns of benchmark over period)]; for example, imagine a strategy, “Strategy A” that intends to benchmark against the returns of $QQQ. For a given timeperiod, X, imagine:
- Strategy A returns 25% over X period
- $QQQ returns 17.5% over X period
Thus, the alpha in this scenario is simply (25% – 17.5%), or 7.5%.
Limitations of alpha
Is Strategy A good? It has positive alpha that seems relatively significant, which is good, right?
Well, it might be. Certainly a negative or lower alpha is worse than a positive or higher alpha, all things else equal. But because there is no consideration to the risk of the strategy used to achieve such return or its volality, the picture is incomplete. If the means by which the 7.5% alpha was generated are extremely risky, unsustainable, unpredictable, etc, it may actually make this strategy with 7.5% alpha undesirable or at least not as desirable as 7.5% alpha sounds in vacuum. In general, highly risky, volatile strategies (which are likely undesirable or at least unlikely to comprise a significant part of an allocators portfolio) tend to have the ability to inflate apparent alpha.
Because alpha is a relatively simple measure and does not incorporate other such considerations, alpha is rarely used in of itself to evaluate an investment by allocators. But it is almost always used as part of the consideration process in some fashion.
“Sharpe ratio” and/or “Jensen’s Alpha” are two common compliments that could used to help fill in the picture.
What is a good alpha?
Building off of the above, whether a strategy’s alpha is “good” or “bad” can only really be ascertained with consideration to the strategy’s objective and risk.
As an example, instead of Strategy A from above, let’s imagine a new strategy, “Strategy B.” Strategy B is heavily hedged against the S&P 500, which generally means that the more the S&P 500 performs positively, the harder it is for Strategy B to itself generate strong performance. You would generally expect that the better the S&P 500 does, the worse Strategy B will fare.
Thus, given Strategy B, if the S&P 500 went up, say, 15% over a given period, and Strategy B was truly heavily hedged against it but itself also went up 10%, an interesting scenario appears. The alpha of Strategy B is -5%, which doesn’t appear to be great. However, on a risk-adjusted basis, this might actually be stupendous returns for Strategy B. Strategy B might significantly outperform the S&P 500 during drawdown periods and only modestly underperform when the S&P 500 has a strong year, and, as such, could be considered by an allocator to be an extremely desirable addition to their overall investment portfolio.
In summary, risk-adjusted returns are generally considered more important than absolute return style measurements, and alpha is only a measure of the latter!
