What Is Alpha?

Alpha is a term used to refer to theoretical or excess returns of an investment. It is a measure of performance on a risk-adjusted basis, comparing the return of an investment to a benchmark index. Alpha can be estimated using regression analysis, which takes into account the volatility (beta) and the correlation of the asset returns to the overall market.

The Meaning of Alpha

At its most basic level, the higher the alpha of an investment, the better its performance. Alpha is a risk-adjusted performance measure, which means that the volatility of the investment has been taken into account when calculating its return. Alpha is a measure of a portfolio’s excess return relative to its benchmark index.

In plain words, alpha is a measure of a fund’s return that is unmatched by its benchmark index. For example, if the S&P 500 Index (the benchmark index) is up 10% over the last year, but a fund is up 15%, then the alpha of the fund would be 5%.

Calculating Alpha

Alpha can be calculated by subtracting the benchmark index return from the fund’s return. The benchmark index can be whatever index the investor wishes to compare the fund’s returns to such as the S&P 500 or Dow Jones Industrial Average.

In formula form, alpha = Fund’s return – Benchmark index return. The alpha value would then correspond to the excess returns of the fund relative to its benchmark index.

Conclusion

In conclusion, alpha is a measure of the return of an investment on a risk-adjusted basis compared to its benchmark index. Simply put, the higher the alpha of an investment, the better its performance, as it suggests the fund has been able to outperform its benchmark index. Alpha can be calculated by subtracting the benchmark index return from the fund’s return. Understanding alpha is important for investors looking to maximise their returns on their investments.