Partial Investment: Impact On Alpha And Portfolio Performance

Alpha is a term used in investing to describe an investment strategy's ability to beat the market. It is a measure of the performance of an investment compared to a suitable benchmark index, such as the S&P 500. Alpha is often used in conjunction with beta, which measures an investment's volatility or systematic risk compared to the overall market. Generating alpha is the goal of many investors seeking higher returns than the market average. However, it's important to note that alpha is not easily attainable, and most actively managed funds fail to achieve it over the long term.

Alpha and beta

Alpha

Alpha (α) is a measure of the performance of an investment compared to a suitable benchmark index, such as the S&P 500. It is often referred to as the "excess return" or "abnormal rate of return" and is used to describe an investment strategy's ability to beat the market, or its "edge". A positive alpha indicates that the investment has outperformed the benchmark, while a negative alpha suggests underperformance. An alpha of zero means that the investment has performed in line with the market.

Beta

Beta (β), on the other hand, is a measure of an investment's volatility or systematic risk compared to the overall market. It is often used as a measure of risk. The market as a whole has a beta of 1, so if an asset has a beta above 1, it is considered more volatile than the market, while a beta below 1 indicates lower volatility. Beta is also used to refer to the returns that can be achieved by simply owning the benchmark index as a passive investment.

Generating Alpha

Generating alpha refers to earning profits from an investment not influenced by overall market trends. It is the goal of many investors seeking higher returns than the market average. Investors use various strategies to generate alpha, such as analysing financial statements, tracking market trends and identifying undervalued assets.

Limitations and Challenges

While alpha is a desirable feature in an investment portfolio, most asset managers are outperformed by index benchmarks. As a result, many investors are losing faith in traditional financial advisors and turning to low-cost, passive robo-advisors.

Additionally, generating alpha consistently over the long term is extremely difficult. Most actively managed mutual funds fail to outperform their benchmarks, despite their resources. Studies suggest that most investors would be better off investing in low-cost index funds instead of trying to beat the market.

Positive and negative alpha

Alpha is a term used in investing to describe an investment strategy's ability to beat the market. It is often referred to as "excess return" or the "abnormal rate of return" in relation to a benchmark when adjusted for risk.

A positive alpha indicates that the actual return on an investment was greater than the expected or benchmark return. This means the investment has outperformed the market and generated superior returns.

On the other hand, a negative alpha indicates that the investment has underperformed and failed to generate returns at the same rate as the market benchmark. It suggests that the investment is not doing well and may be a cause for concern.

It is important to note that alpha is just one metric and should be considered alongside other indicators when creating an investment strategy. Additionally, alpha is more useful in the context of overall portfolio analysis, as diversification can help negate company-specific risks.

Alpha coefficient

The alpha coefficient is a parameter in the single-index model (SIM) and is a key coefficient in the capital asset pricing model (CAPM) used in modern portfolio theory. It is the intercept of the security characteristic line (SCL) and measures an investment's performance in relation to a market index or benchmark.

The formula for the alpha coefficient is:

{\displaystyle \alpha _{i}} : the realised return (on the portfolio)

{\displaystyle R_{M}} : the market return

{\displaystyle R_{f}} : the risk-free rate of return

{\displaystyle \beta _{iM}} : the beta of the portfolio

The alpha coefficient indicates how an investment has performed after accounting for the risk it involved:

• {\displaystyle \alpha _{i}<0} : the investment has earned too little for its risk (or, was too risky for the return)
• {\displaystyle \alpha _{i}=0} : the investment has earned a return adequate for the risk taken
• {\displaystyle \alpha _{i}>0} : the investment has a return in excess of the reward for the assumed risk

For example, a return of 20% may appear good, but the investment can still have a negative alpha if it's involved in an excessively risky position.

Alpha is usually paired with beta, which measures an investment's volatility or systematic risk compared to the overall market. Generating alpha is the goal of many investors seeking higher returns than the market average.

Jensen's alpha

The formula for Jensen's alpha is:

Alpha = R(i) - (R(f) + B x (R(m) - R(f)))

Where:

• R(i) = the realised return of the portfolio or investment
• R(m) = the realised return of the appropriate market index
• R(f) = the risk-free rate of return for the time
• B = the beta of the investment portfolio related to the chosen market index

Calculating Jensen's alpha can result in one of three outcomes:

• Positive: If alpha is positive, it means that the asset outperforms the market or benchmark.
• Negative: A negative alpha means that the security is underperforming the market or benchmark.
• Zero: This occurs when alpha is neutral, meaning the asset performs consistently with or tracks the market or benchmark.

Critics of Jensen's alpha generally believe in the efficient market hypothesis (EMH), which suggests that an asset's price trades at its fair value, accounting for all variables, including risk. Therefore, critics argue that any portfolio manager's excess returns are derived from luck or random chance rather than skill. Despite this criticism, Jensen's alpha remains a widely used tool for evaluating mutual fund and portfolio manager performance.

Alpha in investing

Alpha (α) is a term used in investing to describe an investment strategy's ability to beat the market, or its "edge". It is often referred to as "excess return" or the "abnormal rate of return" in relation to a benchmark, when adjusted for risk.

Alpha is a measure of the performance of an investment compared to a suitable benchmark index, such as the S&P 500. An alpha of 1% means the investment's return was 1% better than the market during the same period; a negative alpha means the investment underperformed the market.

Alpha is used as a yardstick when an investor chooses an active investment strategy, meaning they are trying to outperform the market. It is often used to assess the performance of mutual fund or hedge fund managers and determine whether they add value for their clients.

Alpha is one of five standard performance ratios commonly used to evaluate individual stocks or investment portfolios. The other four are beta, standard deviation, R-squared, and the Sharpe ratio.

Beta (β) is a measure of an investment's volatility or systematic risk compared to the overall market, and is often used in conjunction with alpha. The market as a whole has a beta of 1, so if an asset has a beta above 1, it is considered more volatile than the market, and if its beta is below 1, it is considered less volatile.

Alpha is the excess return on an investment after adjusting for market-related volatility and random fluctuations. It is a measure of risk. An alpha of -15 means the investment was far too risky for the return. An alpha of zero suggests that the asset has earned a return commensurate with the risk, and an alpha of greater than zero means an investment outperformed, after adjusting for volatility.

Generating alpha is the goal of many investors seeking higher returns than the market average. To do this, investors use various investment strategies, such as analysing financial statements, tracking market trends, and identifying undervalued assets.

Alpha is not a guarantee, and it requires careful analysis and research to identify the right opportunities.

Frequently asked questions