Some investors use the ratio to compare different types of portfolios, such as portfolios that invest in different asset classes, and this can result in misleading numbers. ![]() One of these limitations relates to various types of funds. Download the Free TemplateĮnter your name and email in the form below and download the free template now!Īlpha comes with a few limitations that investors should consider when using it. The result shows that the investment in this example outperformed the benchmark index by 8.8%. R m represents the market return, per a benchmarkįor example, assuming that the actual return of the fund is 30, the risk-free rate is 8%, beta is 1.1, and the benchmark index return is 20%, alpha is calculated as:.Beta represents the systematic risk of a portfolio.R f represents the risk-free rate of return.Therefore, Alpha = R – R f – beta (R m-R f) The CAPM formula is expressed as follows: r = R f + beta (R m – R f) + Alpha It then adds the risk premium to the risk-free rate of return to get the rate of return an investor expects as compensation for the risk. It subtracts the risk-free rate from the expected rate and weighs it with a factor – beta – to get the risk premium. The CAPM is used to calculate the amount of return that investors need to realize to compensate for a particular level of risk. Alpha was created as a metric to compare active investments with index investing. The development as an investing strategy created a new standard of performance.īasically, investors began to require portfolio managers of actively traded funds to produce returns that exceeded what investors could expect to make by investing in a passive index fund. The concept of alpha originated from the introduction of weighted index funds, which attempt to replicate the performance of the entire market and assign an equivalent weight to each area of investment. The two ratios are both used in the Capital Assets Pricing Model (CAPM) to analyze a portfolio of investments and assess its theoretical performance. The alpha ratio is often used along with the beta coefficient, which is a measure of the volatility of an investment. Investors in mutual funds or ETFs often look for a fund with a high alpha in hopes of getting a superior return on investment (ROI). The alpha of a portfolio is the excess return it produces compared to a benchmark index. An alpha of zero means that the investment earned a return that matched the overall market return, as reflected by the selected benchmark index. An alpha of negative 5 (-5) indicates that the portfolio underperformed the benchmark index by 5%. Alpha is usually a single number (e.g., 1 or 4) representing a percentage that reflects how an investment performed relative to a benchmark index.Ī positive alpha of 5 (+5) means that the portfolio’s return exceeded the benchmark index’s performance by 5%. A negative alpha number reflects an investment that is underperforming as compared to the market average.Īlpha is one of five standard performance ratios that are commonly used to evaluate individual stocks or an investment portfolio, with the other four being beta, standard deviation, R-squared, and the Sharpe ratio. An alpha of one (the baseline value is zero) shows that the return on the investment during a specified time frame outperformed the overall market average by 1%. ![]() Alpha is a measure of the performance of an investment as compared to a suitable benchmark index, such as the S&P 500.
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