Risk and Return: Alpha

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In our previous blog, we discussed the concept of beta as it applies to the risk and return of an investment. Recall that beta is the price movement in an individual investment that can be accounted for by the price movement of the general market.  If your investment has a beta of 1.0 and the market returns 10%, your investment should also return 10%.  If your investment returns over 10%, the excess return is called alpha. Alpha is derived from a in the formula Ri = a + bRm which measures the return on a security (Ri) for a given return on the market (Rm) where b is beta.

Alpha is the Holy Grail for fund managers who seek to outperform the market on a risk-adjusted basis.  What do we mean by risk-adjusted basis?  We mean performance after factoring out the effect of risk and leverage upon the investment.  As previously discussed, leverage (the use of debt to partially finance an investment) magnifies risk and return.  In an up year, a 2:1 levered investment will make twice the return of its unlevered counterpart.  In a down year, the levered investment will lose twice as much.  More risk, more volatility.

Alpha represents the component of investment return due to selection and/or timing skill of an investor. Studies have found that in any given year, 75% of actively managed portfolios underperform passive market indices. Other evidence suggests that, after fees and expenses, only 5% of hedge fund returns can be accounted for by alpha.  It is thus a rare fund manager who can consistently net outperform a passive index on a risk-adjusted basis.

One technical indicator based on alpha is Jensen’s Index:

Jensen’s Index =    ((Portfolio’s return – Risk-free return)

+ (Market return – Risk-free return)) * Beta

Jensen’s Index shows an investment’s abnormal return above the expected return. A high Jensen’s Index coupled with a low beta would indicated that an investor was achieving superior results while reducing risk – a most desirable combination.

In our next blog, we’ll extend our discussion to look at the Efficient Market Hypothesis.

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Copyright 2010 Eric Bank, Freelance Writer

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