Course 205: Gauging Risk and Return Together, Part 1
Alpha Defined
In this course
1 Introduction
2 Alpha Defined
3 How to Use Alpha
4 The Sharpe Ratio Defined
5 How to Use the Sharpe Ratio

In a nutshell, alpha is the difference between a fund's expected returns based on its beta and its actual returns. Alpha is sometimes interpreted as the value that a portfolio manager adds, above and beyond a relevant index's risk/reward profile. If a fund returns more than what you'd expect given its beta, it has a positive alpha. If a fund returns less than its beta predicts, it has a negative alpha.

As you'll recall from our earlier lesson on risk, beta tells you how much you can expect a fund's returns to move up or down given a gain or loss of its benchmark. For example, if the ABC Fund has a beta of 1.1 in comparison with the S&P 500 and the S&P 500 returns 30% for the year, you would expect ABC Fund to return 33%. (30% x 1.1 = 33%.) Since mutual funds don't necessarily produce the returns predicted by their betas, alpha can be helpful to investors.

To calculate a fund's alpha, first subtract the return of the 90-day Treasury bill, for whatever time period you want to measure, from the fund's raw return. What does a government bond have to do with all this? The T-bill serves as a proxy for a risk-free investment and we're assuming that the return of a mutual fund should, at the very least, exceed that of a risk-free investment. This figure gives you the fund's excess return over the risk-free, guaranteed investment. From that, subtract the fund's expected excess return based on its beta. What's left over is the alpha.

Because a fund's return and its risk both contribute to its alpha, two funds with the same returns could have different alphas. Further, if a fund has a high beta, it's quite possible for it to have a negative alpha. That's because the higher a fund's risk level (beta), the greater the returns it must generate in order to produce a high alpha. Just as a teacher would expect his or her students in an advanced class to work at a higher level than those in a less-advanced class, investors expect more return from their higher-risk investments.

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