When it comes to investing, alpha is a word you’ll often hear bandied about. For many retail investors, it can sound like just another buzzword, but it’s very relevant to your portfolio.
Let’s learn a little more about alpha, what it is, how it’s calculated, why it’s important, and how you can use it to make better investment decisions.
In essence, alpha is a measure of performance. It describes an investment’s ability to outperform the market, with the market represented by a benchmark index. Benchmark indices are designed to represent a particular market, market segment, or asset class, making comparisons possible across different types of investments.
For example, the S&P 5001 is widely regarded as the best single gauge of large-cap U.S. equities and considered a proxy for the overall market. Therefore, it’s a commonly used benchmark against which investment performance is measured. Others include the Russell 2000 (small caps), the Wilshire 5000 (all U.S. stocks), and the MSCI World Index (global stocks).
Any return over the most relevant benchmark value is an investment’s alpha, which is expressed as a percentage.
For example, if the percentage is positive, this is the amount by which an investment has outperformed the benchmark. An alpha of +3% indicates an investment has outperformed its benchmark by 3%. If zero, the investment has performed in line with the benchmark, and if the percentage is negative, the investment has underperformed the benchmark.
In the simplest terms, alpha is calculated by subtracting the benchmark return from the investment return. For example, let’s say that the actively managed U.S. Large Cap Equity Fund returns 16% in year 1, and the S&P 500 returns 12%. The Fund has an alpha of 4%.
The next year, the Fund returns only 10%, while the S&P 500® returns 14%. By subtracting the benchmark return from the portfolio return, the alpha is -4%. The Fund has underperformed its benchmark. It still earned its investors a 10% return for the year, but they could have achieved a better outcome by simply purchasing an index fund or ETF that tracks the S&P 500.
Our simple alpha calculation has ignored a critical point: All returns aren’t equal. We expect riskier investments to provide higher returns. Therefore, we need an alpha calculation that adjusts an investment’s performance by considering the risk (volatility) necessary to achieve those returns.
A more accurate and useful alpha calculation looks like this:
Alpha = Portfolio Return – (Market Return x Portfolio Beta)
Where:
Now, let’s look at the Fund again. Recall that it returned 16% in year 1, and the S&P 500 returned 12%. The simple calculation suggests an alpha of 4% without considering risk. Now let’s assume that the Fund’s beta is 1.3.
Therefore, the Fund’s alpha for year 1 is more effectively calculated as 16% – (12%)1.2 or 1.6%. While incorporating risk means the alpha is lower, it’s still positive, meaning the Fund manager has added value. Using the risk-adjusted alpha, the Fund can be compared with others in its universe to rank its performance.
All investors are effectively trying to capture alpha, and plotting an individual investor’s alpha over time demonstrates the skill the investor brings to the table. After all, if the alpha is consistently negative, the investor is better off investing in a broad market index.
Many investors, though, trust their money to managers by investing in actively managed mutual funds or ETFs. Active management is expensive; investors are likely paying a 0.5–2% fee based on assets under management.2 So understanding and tracking alpha is even more important in these cases.
According to Morningstar’s® semi-annual Active Passive Barometer3, U.S. actively managed equity funds trailed their passively managed peers in 2024, and this is certainly not the first time. This is why many professionals recommend investors put their money in passive funds that replicate the performance of the relevant benchmark.
But some managers do add significant value. When considering an actively managed fund, it’s wise to look at alpha generated annually and over various time horizons (1, 3, 5, and 10 years, for example) to gain an understanding of how performance varies according to market conditions. Styles and strategies fall in and out of favor, so the market context can help in comparing performance between funds and their benchmarks.
Although you want a fund manager to generate alpha, be wary of a manager who always generates alpha. They may look like a genius, but they may be another Bernie Madoff, whose always-positive-returns were a way to bring in more assets under management to keep the Ponzi scheme alive. Real results will vary.
Alpha can be useful in a number of ways.
Measuring portfolio performance: Alpha isn’t just about individual investments or funds; it applies to your overall portfolio too. A positive alpha across your portfolio means you’re outperforming a similarly composed benchmark while a negative alpha indicates underperformance. With this insight, you can better analyze your decisions and improve your investing.
Comparing investments with benchmarks: Before you invest in a stock, mutual fund, or ETF, look at its historical performance relative to a benchmark. Many investment platforms and financial information services provide alpha data for funds. Focus on investments that generate consistent positive alpha over the long term, indicating that they’ve delivered excess returns over time.
Evaluating fund managers: Before you invest in actively managed funds, examine their track record. Has the manager consistently delivered positive alpha after accounting for fees? If not, you might want to consider a low-cost index fund that seeks to match, rather than beat, the market.
An important thing to remember when using alpha as part of the investment decision-making process is that you can’t compare apples and oranges. Alpha should only be used to evaluate the same types of investments. For example, you can’t reasonably compare the alpha of a large-cap portfolio with the alpha of a small-cap portfolio. That goes double for comparing portfolios invested in different asset classes.
The choice of benchmark is also of critical importance. Choose the wrong benchmark and alpha won’t be an accurate measure of performance. The S&P 500, while representing the overall market, is not appropriate for every fund. For example, a small cap growth fund would likely choose the Russell 2000, which tracks 2000 small cap stocks in the United States, as its benchmark. Some more esoteric funds may not have an existing index against which to benchmark. If this is the case, analysts may construct a simulated index using various models and algorithms.
Understanding alpha can empower investors to make better decisions. It demystifies fund performance, brings clarity to portfolio management, and ensures that you are investing with both eyes open.
By adding alpha to your investing toolkit, you can take a more informed approach to pursuing your financial goals.