Delving into funds: What is alpha?

Julie Brownlee, Fsp Invest, 21 Nov. 2014

Tags: alpha, what is alpha, funds, unit trusts, using alpha, investing

If you’ve looked at funds and unit trusts, you might have come across the term ‘alpha’.

So what does alpha mean?

Let’s take a closer look…

What is alpha?

Alpha is a way of measuring a fund manager’s performance.

Put simply, alpha is the amount of value a fund manager adds or takes away from an investment portfolio.

You can look at alpha is two ways…

Two ways of using alpha

The first way of using alpha is to compare the performance of the fund manager’s portfolio against a benchmark index.

For example, you could compare the investment returns of a portfolio of South African shares with the returns of the Johannesburg Stock Exchange’s All Share Index over a specific period of time.

Say over the time period, the fund manager’s portfolio returned 15%. Over the same time period, the benchmark index returned 10%.

Then the fund manager will have generated positive alpha of 5%.

The other way of using alpha is to take into account the risk profile of a portfolio and compare that with its risk-adjusted returns with what a financial model would predict it should achieve.

Alpha compares a portfolio’s return with those predicted by something known as the capital asset pricing model (CAPM).

CAPM states that the basis of the expected is the interest rate on government bonds, plus an extra bit relative to the risk the fund manager takes on. This is the risk premium.

For example, CAPM predicts a portfolio return of 8%. The actual portfolio return is 10%. This means the fund manager achieved a positive alpha of 2%.

So there you have it, what alpha is.

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