What is Alpha?
Alpha represents the portion of a portfolio's return that cannot be explained by market movements. If a fund returns 12% in a year when its benchmark returns 10%, the fund has generated 2 percentage points of alpha. The concept was formalized by Michael Jensen in 1968 as part of his evaluation of mutual fund performance, and it is used as a yardstick for judging active managers.
Generating and Identifying Alpha
Sources of alpha include superior stock selection, market timing, and exploiting informational advantages. The SPIVA scorecard has found that more than half of actively managed U.S. large-cap funds underperform the S&P 500 over 15-year periods. Risk-adjusted metrics such as the information ratio, which divides alpha by tracking error, are also used to evaluate a manager's alpha.
Key Considerations
Positive alpha in a single year may reflect luck rather than skill. Statistical tests require long track records to distinguish genuine ability from random variation. Fees also erode alpha: a fund charging 1.5% annually needs to generate at least 1.5% of gross alpha just to match its benchmark net of costs.