Course 205: Gauging Risk and Return Together, Part 1
How to Use Alpha
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

It seems to follow, then, that you would want to find high-alpha funds. After all, these are funds that are delivering returns higher than they should be, given the amount of risk they assume.

But alpha has its quirks. First, it's dependent on the legitimacy of the fund's beta measurement. After all, it measures performance relative to beta. So, for example, if a fund's beta isn't meaningful because its R-squared is too low (below 75), its alpha isn't valid, either.

Second, alpha fails to distinguish between underperformance caused by incompetence and underperformance caused by fees. For example, because managers of index funds don't select stocks, they don't add or subtract much value. Thus, in theory, index funds should carry alphas of zero. Yet many index funds have negative alphas. Here, alpha usually reflects the drag of the fund's expenses.

Finally, it's impossible to judge whether alpha reflects managerial skill or just plain old luck. Is that high-alpha manager a genius, or did he just stumble upon a few hot stocks? If it's the latter, a positive alpha today may turn into a negative alpha tomorrow.

Next: The Sharpe Ratio Defined >>

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