What Is Alpha?
Alpha is typically considered the additional return — compared to a broader market return — that an active manager generates (over and above what might be anticipated given the level of investment risk taken).
Imagine that one investor (Investor A) buys every U.S. stock and that this hypothetical investment generates a return of 5% over one year. Meanwhile, another investor (Investor B) decides to invest in only a selection of U.S. stocks, favoring some more than others. Subsequently, Investor B buys and sells some stocks with a view to pocketing gains and avoiding declines. After a year, Investor B who has actively bought and sold certain stocks has generated an 8% return, with a volatility of returns over the period that was in line with the broader market’s volatility.
In this simplified imaginary example, there was a 3% difference in returns between the passive investor (A) who, in effect, “bought the market” and the active investor (B), who was more selective. So, in this case, the active investor who sought to use investment skill to outpace the market generated a positive alpha, recording an excess return of 3%. If Investor B had lagged the broader market return, the alpha would have been negative. Meanwhile, if Investor B's return had matched the market, no alpha would have been generated.
Though alpha is often thought of as the part of an investment return that results from an investor’s “skill,” this is not necessarily the case. In financial theory, alpha is defined as the part of an investment return that is not the result of the movement of the broader market. This definition leaves open the possibility that the excess return generated by the active investor may have also resulted from luck, rather than skill. When considering an investment in a particular mutual fund, it is, therefore, important to consider the fund manager’s longer term track record.