Should You Bank on Alpha?
In Part 3 of our series on modern portfolio theory, we discuss the alpha data point's reliability in determining a fund's risk/reward profile.
Question: I often hear fund managers touting the fact that they've generated positive alpha. Should I be impressed?
Answer: You're right--in some circles, being able to generate alpha is touted as the holy grail of investing; it's an indication that a manager has been able to generate an above-average return relative to the risk that he or she is taking on. But like beta, which we discussed in a previous article, alpha has some useful applications as well as some limitations. Before you put too much stock in the statistic, it's important to know exactly what alpha is telling you and how it's calculated.
How Alpha Works
Although alpha precedes beta in the Greek alphabet, a fund's beta is a necessary precursor to calculating its alpha. To briefly recap, beta measures an investment's volatility, or more specifically, its sensitivity to the movements of a market index. On days when a market index generates a positive return, a fund with a high beta would be expected to gain even more than the index. On the flip side, the high-beta fund would be expected to lose more than the index during market downdrafts.
Esther Pak does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.