Course 205: Gauging Risk and Return Together, Part 1  
Alpha Defined  

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 90day 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 Tbill serves as a proxy for a riskfree investment and we're assuming that the return of a mutual fund should, at the very least, exceed that of a riskfree investment. This figure gives you the fund's excess return over the riskfree, 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 lessadvanced class, investors expect more return from their higherrisk investments. Next: How to Use Alpha >> 
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