Alpha is often used for the measurement of performance of a stock on a risk-adjusted basis. The return of a portfolio implies the performance of that particular portfolio, which is compared to the market return used as a benchmark. The excess return relative to the market return is considered to fund Alpha.
It is generally used for the similar type of investments such as mutual funds and it is represented in terms of percentage. For example, if the Alpha value is 5 that represents that portfolio has performed 5% better than the market and if its value is -1 it represents that the portfolio performance is worse than the market by 1%.
Alpha is one of the technical risk ratios that are used as an indicator to determine the risk-return relationship of a portfolio. It is the return on an investment that is not a result of the movement in the market. It is given by the equation:
Alpha (α) = Re – β*Rm
Re is the return on the security
β is the regression coefficient, which determines the sensitivity of the market
Rm is the return on the market portfolio
In the above equation, the return of the security is regressed upon the market return when the market risk is equal to zero α is equal to the risk-free rate of the security. CAPM analysis aims to estimate the return on portfolio based on risk. For example, through CAPM analysis, the estimate of a portfolio return should earn 10% based on the portfolio risk, but in actual the portfolio earns 15% this determines portfolio α which would be 5% of the estimation of CAPM.
There are certain limitations which should be taken care before accounting Alpha.
- There is a tendency to use its values to compare a different kind of funds with one another of different which should not be done as it is useful for comparing same asset class.
- Since Alpha is calculated relative to a benchmark, it is important that appropriate benchmark is chosen. In some cases, due to excessive fluctuation, it is difficult to find a suitable benchmark index of the market in such cases, advisors can take the help of algorithms and another model to simulate a benchmark for comparative purposes.
- If the Alpha value is less than the percentage charge by the financial advisors for their service it creates pressure on the managers to produce better results. For example, if a financial advisor charges 1% for a service to the client and he is able to generate an Alpha of 0.75 on the portfolio for his client, the fee charged is in excess of Alpha that he has generated which will result in the net loss on that portfolio.