Alpha Finance
The alpha coefficient allows investors to accurately assess the average level of income that brings the investment portfolio.
Accourding to the Investopedia “Alpha” (the Greek letter α) is a term used in investing to describe a strategy’s ability to beat the market, or it’s “edge.” Alpha is thus also often referred to as “excess return” or “abnormal rate of return,” which refers to the idea that markets are efficient, and so there is no way to systematically earn returns that exceed the broad market as a whole.
Essence and history of alpha
The alpha parameter was developed by Michael Jensen in 1968, he was Tested hypothesis of finding an effective market. Jensen tried to determine whether the historical profitability of portfolio managers judged their ability to outperform the market.
At that time everyone was using a simple approach — the income received during the year from a mutual fund was compared with the return on the portfolio itself for the reporting period (also for the year). Michael Jensen tried to present the result by a common factor, for example, the S&P 500. Such analogies led investors into a misconception because the main parameter (the risk in the process of making a particular transaction) was not taken into account.
Shortly before that (in 1964), William Sharpe published his “ Capital Asset Pricing Model, CAPM”, In this work, he stated that portfolio returns increase along with general risks. In fact, it was about calculating the “beta coefficient”. According to this theory, portfolios during the year can either come out victorious in the fight against the market, or lose to it.
In turn, Jensen set himself another task — he wanted to find out a correlation between time, intuition and skills of portfolio managers, which regularly beat the market. He understood that the model of Sharpe’s CAPM was ineffective in this case. It doesn't take into consideration the possibility of consistently improving results. So the alpha coefficient appeared.
The new formula with the alpha coefficient made it possible to consider the contribution to the overall profitability not only of the factors of the market itself but also of the manager’s experience, as well as the availability of confidential data.
By adding the coefficient alpha to the formula, Jensen placed the portfolio level above the level of market capital. By doing that He made possible to take skills and knowledge of the investor into account.
In his theory, Jensen did not try to convince that a number of managers regularly beat the market, his task was to take into account this possibility in the formula. With the help of a special coefficient, it became possible to express such a chance in the numerical display.
The alpha coefficient formula
A simple formula is used to calculate the alpha coefficient, which takes into account the Sharpe Ratio ( Beta of the investment):
First, let us look at the Beta of the investment formula
- Where “B” is the Beta coefficient itself;
- Cov(RaRb) — is a parameter that displays the covariance of asset and market;
- Va(Ra) — is a parameter that displays the variance of the market.
The above calculation is designed to (a) help investors understand whether a stock moves in the same direction as the rest of the market and (b) how volatile it is compared to the market. For beta to provide any insight, the “market” is used as a benchmark and should be related to the stock.
Next is Alpha of the investment formula
- Where “A” — is the alpha coefficient itself;
- “Rp” — is a parameter that displays the average return on the investment portfolio for a certain period of time;
- Rf —is a parameter that displays the average return of the investor without risk(risk-free rate);
- B — Sharpe ratio (Beta of the investment);
- Rm — is the average profit of an ideal investment portfolio (used as a benchmark).
The main challenge of this calculation is to select the required initial parameters reflecting the activities of certain investment funds(managers). But in recent years, thanks to the transparency of the work of many funds and the Internet, it is possible to assess the quality of work of various managers over the past few years.
Advantages and Disadvantage of Alpha
The parameter, developed by Michael Jensen in 1968, has its positive and negative points. At the same time, it was initially used exclusively to assess the effectiveness of the work of managers, but today it has received widespread use.
Advantages
- When forming an investment portfolio, you can take into account not only the degree of profitability of the asset used, but also a risk of the current investment.
- With the help of the alpha coefficient, the investor accurately determines the level of risk that is necessary to obtain the profit. As a result, if two portfolios show equal return, but a different level of risk, then preference is given to investments with lower risk.
- The alpha coefficient indicates whether an investor can invest in an asset with a certain return and at a specific level of risk. In the case when the level of profitability exceeds the number calculated by the Sharpe model, one can draw conclusions about positive alpha.
- The alpha coefficient shows how well the manager works with the assets and whether he can be trusted.
Disadvantages
- You need information on the profitability of funds over several years in order to calculate the Alpha, which causes certain difficulties for potential investors.
- The alpha coefficient depends on another coefficient — beta, the disadvantages of which affect the overall result. The beta coefficient itself depends on the index that is the basis for calculating the correlation. If we take the indices of the Russian market as a basis, then they are strongly dependent on the cost of gas and oil. As a result, when investing in other sectors of the economy, the accuracy of the alpha coefficient is questionable.
- We can speak about the accuracy of the alpha coefficient only if the correct theoretical background is used for the calculation(for example - risk).
- The calculation of alpha will not give an exact answer, is the fund manager really talented or is he just lucky.
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