Alpha

What Does Alpha Mean in Investments?

Alpha is a measure of the success of your investment or rather outperformance against the benchmark. It measures on how much the fund or stock has performed in the general Market. Alpha is usually a single number (e.g., 1 or 4), and is expressed as a percentage that reflects how an investment performed relative to a benchmark.

A positive alpha of 1 means that the fund has outperformed its benchmark index by 1percent, while a negative alpha of -1 would indicate that the fund has produced 1 percent lower returns than its market benchmark. An alpha of zero means that the investment earned a return that matched the overall market return as reflected by the selected benchmark index. So, basically, an investor’s strategy should be to buy securities with positive alpha.

Alpha is one of five standard performance ratios that commonly used to evaluate individual Mutual Funds/stocks or an investment Portfolio. The other four being Beta, Standard Deviation, Sharpe Ratio and R-Squared.

Alpha Formula

Jensen's alpha was first used as a measure in the evaluation of mutual fund managers by Michael Jensen in 1968.

Alpha = {(Fund return-Risk free return) – (Funds beta) * (Benchmark return- risk free return)}.

Example:

• Fund return- 10%
• Risk free return- 8%
• Benchmark return- 5%
• Beta of Fund- 0.8

By computing with above formula we will get alpha as 4.4 for this mutual fund.