Alpha is a measure used to calculate the performance of an investment portfolio against a benchmark, usually a stock index. Aaron Villa explains that the degree to which an investor has managed to “get ahead” of the market over a period of time. Alpha can be positive or negative, depending on its proximity to the market.
Alpha is not only used as a measure of the portfolio against the underlying market. Indeed, it is also used to indicate the performance of a fund manager (who implements the strategies and manages the trading activities) and his capacity to add value.
The basic alpha calculation simply subtracts the total return on an investment from the benchmark returns, over the same time period.
However, it is common practice to use the capital assets pricing model (CAPM), to get a more detailed overview of a portfolio’s performance. With this calculation, we subtract the risk-free rate of return (ROR) from the expected return, then we subtract the beta to obtain the risk premium. This premium is then multiplied by the market return (reference value) minus the risk-free rate of return.
Suppose the expected return is 12% after one year, the risk-free rate of return is 10%, the beta is 1.2, and the benchmark is 11%. Your alpha calculation would then be: 12 – 10 – 1.2 x (11 – 10).
This means that the alpha is 0.8%. This positive percentage means that the portfolio is outperforming the market. It should be noted that the alpha of a portfolio is subject to change if positions are subject to greater volatility, resulting in a change in beta.
Alpha can give fund managers a general idea of how their portfolios are performing relative to the rest of the market. In trading and investing, alpha can be a useful tool in establishing market entry and exit points.
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