Alpha is simply a Risk Adjusted Performance Measure (RAPM), which is used to assess on a risk adjusted basis, investment performance relative to a benchmark. Alpha, however, is much more than that.
Michael Jenson was the person to first define Alpha back in 1968 while investigating on the Emerging Efficient
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Market Hypothesis, wherein, he was trying to find out whether a Mutual Fund’s historical returns pointed out capabilities of some managers to outperform the overall market. The simplest approach would be to compare a Mutual Fund’s annual return to that of the Share Market Portfolio’s, which would have been represented by certain broad index. E.g. S&P 500.
However, such comparisons could be highly misleading as it doesn’t consider risk into consideration. In the year 1964, William Sharpe had come out with Capital Asset Pricing Model, popularly known as CAPM, which interprets that a Portfolio’s Expected Return would increase with its own Systematic Risk, Beta as per the formula.
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E(Zp) = zf + β[E(Zm) – zf ]
The above formula depicts that the Portfolio Expected Return equals to the Risk Free Rate in addition to the Portfolio’s Beta, multiplied by the Expected Excess Return for the Market Portfolio over its Risk Free Rate.
Keeping the above formula in mind, Jenson was interested to know whether a Mutual Fund Manager adds any value over a longer term. Can a manager use his skills or have access to specific privileged information outperform the share market on a consistent basis? It’s not a situation where there are good or bad years on a random basis, but consistency with regards to the fund’s performance. The model designed by Sharpe doesn’t take that possibility into consideration and Jenson wanted to add the term Alpha to that formula.
E(Zp) = α + zf + β[E(Zm) – zf ]
The Alpha added a constant positive contribution to the Portfolio Expected Return because of the Fund Manager’s skill-set and access to privileged information.
Jenson’s test results on his formula offered support to the Efficient Market Hypothesis and suggested that not a single Fund Manager has positive Alpha. In the current day, some review Jenson’s work, but they are aware of what Alpha is today. There are several RAPM formulae at a Fund Manager’s disposal, which includes the Sharpe Ratio or the Treynor Ratio, however, none of them are as popular as the Alpha. Alpha is not calculated that often, partially due to the fact that it needs several years of historical data. Additionally, it may be because Jenson’s inference has been reaffirmed many times. The Empirical Alphas of Fund Managers mostly tend to be negative.
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Alpha has just been a symbol in today’s financial life. It’s a key word for a Fund Manager and that can outperform the share market. The job of an Active Fund Manager is to generate Alpha, which is nothing but out-performance. If an active fund management were to be a religion, the Alpha would the God!