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Alpha is a term used in investing to refer to the ability of an investment strategy to outperform the market, or its “edge.” Thus, alpha is also known as “excess return” or “abnormal rate of return,” which refers to the idea that markets are efficient and that there is no way to earn returns that outperform the broad market as a whole.

Alpha is frequently used in conjunction with beta (the Greek letter), which measures the overall volatility or risk of the market, also known as systematic market risk.

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In finance, alpha is used as a performance metric, indicating when a strategy, trader, or portfolio manager outperforms the market return over a given time period. Alpha, also known as the active return on investment, measures an investment’s performance against a market index or benchmark that is thought to represent the market’s overall movement.

Key Takeaways

  • The term “alpha” refers to the excess returns earned on an investment over the benchmark return
  • Active portfolio managers seek to generate alpha in diversified portfolios, with diversification intended to eliminate unsystematic risk
  • Because alpha represents a portfolio’s performance relative to a benchmark, it is frequently regarded as the value that a portfolio manager adds to or subtracts from a fund’s return
  • Jensen’s alpha considers the capital asset pricing model (CAPM) and includes a risk-adjusted component in its calculation.

Understanding Alpha

Alpha is one of the five most commonly used technical investment risk ratios. Beta, standard deviation, R-squared, and the Sharpe ratio are the others. All of these statistical metrics are used in modern portfolio theory (MPT). All of these indicators are designed to assist investors in determining an investment’s risk-return profile.

Active portfolio managers seek alpha in diverse portfolios, with diversification designed to eliminate unsystematic risk. Because alpha indicates a portfolio’s performance compared to a benchmark, it is frequently thought to represent the value that a portfolio manager adds to or subtracts from a fund’s return.

Seeking Investment Alpha

Alpha is a popular metric for ranking active mutual funds and other sorts of investments. It is sometimes written as a single figure (such as +3.0 or -5.0), and it typically refers to a percentage indicating how the portfolio or fund performed in comparison to the relevant benchmark index (i.e., 3% better or 5% worse).

A more in-depth examination of alpha may also include “Jensen’s alpha.” Jensen’s alpha is calculated using the capital asset pricing model (CAPM) market theory and contains a risk-adjusted component. The CAPM uses beta (or the beta coefficient) to determine the expected return of an asset based on its own beta and the projected market returns. Investment managers utilise alpha and beta together to calculate, compare, and analyse returns. To know about the demand draft, click here.

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