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Alpha

A measure of the difference between a fund's actual returns and its expected performance, given its level of risk as measured by beta.

A positive alpha figure indicates the fund has performed better than its beta would predict. In contrast, a negative alpha indicates the fund's underperformance, given the expectations established by the fund's beta.

All MPT statistics (alpha, beta, and R-squared) are based on a least-squares regression of the fund's return over Treasury bills (called excess return) and the excess returns of the fund's benchmark index.

Alpha can be used to directly measure the value added or subtracted by a fund's manager.

Alpha depends on two factors:

1) the assumption that market risk, as measured by beta, is the only risk measure necessary 

2) the strength of the linear relationship between the fund and the index, as it has been measured by R-squared.

In addition, a negative alpha can sometimes result from the expenses that are present in a fund's returns, but not in the returns of the comparison index.

Example: A fund has an alpha of 0.86, a beta of 0.96 and an R-squared of 97. The high R-squared lends further credibility to the accuracy of the fund's alpha and beta. The alpha of 0.86 indicates that the fund produced a return 0.86% higher than its beta would predict.

See also Beta

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