Alpha

You must have seen ads on TV where daredevil actors perform death-defying stunts. At the end of such ads, there's usually a notice saying something like 'This film was shot with trained stuntmen, please don't try this yourself.' Well, guess what, calculating—and using—alpha is a little bit like that. We could just leave you with some arcane maths and imply that everyone who invests in funds can—and must—use concepts like alpha. But it isn't really so. We'll give you a basic understanding of the concept, enough to make sense of alpha when you do come across it, but as far as calculating alpha goes, as the TV Ads say, don't try this stunt at home.

Alpha is part of what is called modern portfolio theory, a set of techniques that analyse investing in a somewhat academic manner. Alpha is used along with beta and R-squared.

Beta is a measure of the sensitivity of a fund to its index. It shows the relation between the funds returns and that of its index. A beta of 1.2 means that the fund tends to rise and drop 20 per cent more than the index does.

Beta cannot be used in isolation. Another indicator called R-squared has to be used to validate beta. Thus a 1.2 beta fund is more volatile than a fund with a beta of one. Beta is therefore a measure of volatility. You are taking a higher risk in investing in such a fund.

Why would you, the well-informed and goal-oriented investor, take such a risk? Surely, to be able to earn higher returns. How would you know if the returns from a high-beta fund are enough to justify the higher risk that it entails? That's where alpha comes in.

Alpha tells you whether that fund has produced returns justifying the risks it is taking by comparing its actual return to the one 'predicted' by the beta. Say, a fund can be expected to earn—based on its beta—a return of 15 per cent in a given year. However, it actually fetches you 18 per cent. Then the alpha of the fund is simply 18 - 15 = 3, that is, 3.

Alpha can be seen as a measure of a fund manager's performance. This is what the fund has earned over and above (or under) what it was expected to earn. Thus, this is the value added (or subtracted) by the fund manager's investment decisions. This can be clearly seen from the fact that Index funds always have—or should have, if they track their index perfectly—an alpha of zero.

Thus, a passive fund has an alpha of zero and an active fund's alpha is a measure of what the fund manager's activity has contributed to the fund's returns. On the whole a positive alpha implies that a fund has performed better than expected, given its level of risk. So higher the alpha better are returns.

One crucial issue that impacts all three is how closely the chosen benchmark actually correlates with the fund you are examining. The lower the R-squared—meaning the less the correlation between the fund and its index—the less meaningful are the beta and alpha.

Unfortunately, there's no objective way of determining the exact cut-off point for R-squared below which the beta and the alpha are meaningless. For all the implied precision of the complex-sounding mathematics that goes into these measures, the cut-off point for a good R-squared is a judgment call. Many analysts take 0.80 as the cut off point, but most will get a feel for other measures of a fund and then see to what point the R-squared is relevant.

Like we said, don't try this at home.