What Is Alpha Investing?

To understand what alpha is, investors must know how to calculate relative risk and excess return compared to a benchmark index and what this suggests.

Everyone wants to get good value for their money. When building an investment portfolio, savvy investors typically analyze how a particular stock, exchange-traded fund (ETF), or mutual fund performs compared to the overall stock market. To make this assessment, you’ll need an investment’s relative risk and return, also known as its alpha—but what is alpha?

What is alpha in stocks, and how do you calculate it? We’ll answer these questions and discuss the pros and cons of alpha, plus how it differs from beta.

What is alpha in investing?

Also sometimes known as Jensen’s alpha or Jensen’s performance index, alpha is a numerical figure representing an investment’s risk-adjusted outperformance (or underperformance) compared to predicted returns. Basically, it’s a measure of how much a stock is beating the market.

A positive alpha means a stock outperformed its target stock market index, whereas a negative alpha indicates it underperformed compared to the benchmark. For example, an alpha of 3.0 means a fund achieved 3% excess returns above its benchmark. A -5.5 means it performed 5.5% worse.

Alpha features prominently in modern portfolio theory alongside crucial performance metrics like the Sharpe ratio, standard deviation, and R-squared. Hedge fund and portfolio managers strive to generate alpha for their investors by beating an investment’s expected return given its estimated risk.

(Composer makes it easy to incorporate seeking alpha into your investing strategy. Sign up for Composer’s 14-day free trial and get started today.)

How is alpha calculated?

Alpha calculations vary depending on the model used, the asset class, and the benchmark index. Basic alpha calculations subtract an investment’s total return from its benchmark returns, meaning you can’t use it to compare performance between different asset classes.

For example, some ETFs, like JSMD (Janus Small/Mid Cap Growth ETF), are designed to mimic a particular index. In contrast, other ETFs, like AGOX (Adaptive Alpha Opportunities ETF), do not mimic a specific index.

Portfolio managers use a capital asset pricing model (CAPM) to calculate alpha. The CAPM formula subtracts a portfolio’s expected return rate from its actual rate. To get the expected return, you need to know the market return, risk-free rate of return, and expected risk level, or beta.

The CAPM formula for alpha appears as follows:

α = R – R(f) – β ✕ (R(m) – R(f))

Where:

α = alpha

R = the actual rate of return

R(f) = the risk-free rate of return

β = beta

R(m) = market return

Assume a mutual fund realized a 12% return last year, and its benchmark index fund earned an 8% return. The mutual fund has a beta of 1.5 and a risk-free rate of return of 5%. When you plug these values into the alpha formula, you get:

12% – 5% – 1.5 ✕ (8% – 5%) = 2.5

Based on these values, the mutual fund has an alpha of 2.5, meaning it outperformed its benchmark index by 2.5%.

Pros and cons of alpha

Some investors rank alpha among the most crucial investing indicators. Although it provides vital information regarding an asset’s performance, you shouldn’t make investment decisions based on alpha alone.

Pros of alpha

Performance measurement: Alpha measures an investment’s performance compared to its benchmark, allowing investors to identify stocks and funds that outperform and generate positive alpha returns.
Skill assessment: A high alpha can indicate a successful investment strategy, making it easier for investors to evaluate a fund manager’s financial decision-making skills.
Risk-adjusted returns: Alpha considers an investment’s risk when calculating its performance. The higher the alpha, the greater the potential for risk-adjusted returns relative to the market.

Cons of alpha

Not foolproof: Sharp price movements or volatile market conditions can make it difficult for investors to distinguish between alpha returns derived from skill and pure luck.
Market conditions: Market conditions can significantly impact alpha. Bull markets make it easier to generate positive alpha. Conversely, bear markets make it more challenging.
Data limitations: You need accurate price information to correctly estimate alpha, meaning incomplete historical data can result in misleading alpha calculations.
Doesn’t consider costs: Alpha doesn’t consider management fees, taxes, or transaction costs, which can diminish investment returns and undermine alpha’s efficacy for estimating performance.
Complexity: Investors must be able to interpret complex stock market indicators and financial reports to understand alpha. Beginner investors may struggle to successfully leverage alpha analysis.

Applying alpha to investing

Many investors leverage alpha in value investing strategies. Although you can purchase alpha-seeking active ETFs like QVAL, you could also construct a unique portfolio of value stocks and ETFs. Seeking alpha generation in your portfolio can help you identify assets with positive risk-adjusted returns compared to similar asset classes or the overall market.

Searching for high-alpha investments can also simplify your decision-making. By identifying undervalued ETFs, mutual funds, and small-cap stocks, alpha assessment helps you to build diverse portfolios that balance risk while maximizing potential returns.

Alpha vs. beta

Alpha and beta frequently appear together in modern portfolio theory analysis. Although they share traits, these indicators also differ in several primary aspects.

Definition

Alpha measures an investment’s relative risk and excess return compared to its benchmark index.

Beta measures a security’s sensitivity to market movements compared to the overall market.

Interpretation

Alpha provides insight into an investment manager’s skill at adding value via security selection, portfolio construction, and strategy execution. A positive alpha indicates outperforming an index, whereas a negative alpha indicates underperformance.

Beta approximates a security’s systematic risk relative to a market index—the more volatile the asset, the greater the risk. A beta greater than 1.0 suggests higher risk but higher potential returns. A beta below 1.0 suggests lower risk but lower potential returns.

Risk and return

Alpha considers risk when evaluating return, allowing investors to assess how well an asset or strategy performed given the expected risk.

Beta evaluates risk but not return compared to the overall market, meaning the metric’s value lies solely in its ability to estimate how investments react to market movements.

Application

Alpha helps investors compare actively managed investments and passive investments like index funds. A positive alpha suggests a stock or fund offers a greater risk-adjusted return than its target benchmark, indicating overall strategy or management efficacy.

Investors use beta to diversify their portfolios. Selecting assets with various risk exposures helps to balance volatility and return, enabling investors to create portfolios that meet but don’t exceed their risk tolerance.

Using alpha in Composer

Building alpha-focused strategies in Composer is simple. Here’s how:

Visit Composer’s website and sign up for a 14-day free trial. After your trial ends, you can go Pro and trade live or maintain a free account with unlimited backtesting, data insights, and simulated strategy building.

2. Build a symphony

To create a new investment approach (aka symphony), log into your account and click “Create,” then “+ New Symphony.” You can use Composer’s no-code interface to build your strategy or click “Create with AI” to prompt Composer’s ChatGPT-4-powered AI tool to create a strategy for you.

3. Assess alpha

You can find your strategy’s alpha in the tables below the backtest chart. Along with alpha and beta, this table includes performance indicators such as standard deviation, Calmar ratio, Sharpe ratio, and max drawdown.

You can construct your own strategy or adopt pre-built strategies created by Composer community members. Composer automatically rebalances your portfolio in response to market movements, giving you more time to backtest and edit your strategy to find what works.