Alpha is a risk ratio which measures gains or losses relative to a benchmark, indicating whether an investor is being compensated with a return greater than the volatility risk being taken. Alpha’s counterpart, the Beta figure, measures how closely an investment follows movements in the market as a whole or, when examining mutual funds, how similarly the funds move to their relevant indexes.
Alpha is expressed as integers, which can be translated into percentage points above or below a benchmark for a time period. Investors are interested in higher Alpha figures: the larger the positive Alpha, the more the fund in question has outperformed its benchmark. An Alpha of 2 indicates a performance 2% greater than its benchmark; inversely, a -2 Alpha would denote 2% underperformance.
Alpha and Beta are normally used with regards to mutual funds and managed portfolios. A positive Alpha indicates performance above the benchmark, while a negative Alpha means underperformance. Both figures are historical, not predictive, measurements.
While a strong Beta would indicate that a fund is “sticking with the pack,” a strong positive Alpha indicates returns in excess of expectations relative to the benchmark. As with wolves, the term Alpha denotes leadership and aggression, but these characteristics can come with increased risk.
Understanding risk is vital to understanding the Alpha figure. In finance, it is common to hear about the correlation between risk and return. Risk can be defined as exposure to the possibility of loss of an asset; it might be used to denote the cause of the potential loss, or the probability of the loss. More risk may yield a higher return, but it also has the potential for more loss. The situation requires that an investor willing to take such a risk must provide the capital to fund the investment which may grow or may fail.
Risk ratios are not designed to predict future results. Instead, they help portfolio managers and investors to discern between strong and weak investments over a certain time period. Investors can benefit from risk ratios as they learn to anticipate volatility and remove emotional bias from their decision-making.