A number of definitions of alpha funds can be found on the internet but I am not sure that they clarify things.
Here is an example from Wikipedia: “Alpha is a risk-adjusted measure of the so-called active return on an investment. It is a common measure of assessing an active manager’s performance as it is the return in excess of a benchmark index. Note that the term active return refers to the return over a specified benchmark (eg. the S&P 500) whereas excess return refers specifically to the return over the risk-free rate. It is a common error to confound these two terms and the reader is cautioned to make a careful distinction between them when studying or discussing investments. The difference between the fair and actually expected rates of return on a stock is called the stock’s alpha.”
By definition, alpha is a measure of the difference between a fund’s actual returns and its expected performance, given its level of risk as measured by its beta. Beta is the measure of an asset’s risk in relation to the market. Therefore, a beta of one means that the asset is likely to move in line with the market. If the fund has a beta of one and produces the same return as the market, no alpha has been generated.
A positive alpha suggests better performance than a fund’s beta would predict. A fund that aims to produce alpha therefore sounds pretty tempting, doesn’t it?
I prefer the following explanation from Iluka Research, simply because it explains alpha using pure common sense.
You decide to invest in a stockmarket which is capitalised at $100bn. Over time, the market rises by 10 per cent and so is worth $110bn. Investors have therefore profited by $10bn, making an average gain of 10 per cent.
They also share average risk. There is only so much risk in the market, in this case the potential to lose $100bn. If you buy part of the whole market through an index-tracking fund, you will share that average risk and reward cost-effectively. This market return is beta, as described above, and anyone can have it. It is virtually free.
If beta is not enough for you, then you can start hunting for greater returns by weighting stocks in different proportions to the index. If these decisions lead to an increased return with no additional risk, then alpha has been generated. However, as the total return in this example is only $10bn, one person’s gain must be another person’s loss. The critical point here is that the total amount of alpha is zero. There is no net alpha. It is a zero sum game.
If the stockmarket beta can be obtained very cheaply through index-tracking funds, why search for alpha? Simply by spending money on fund management fees, you are going to be earning less than beta unless you are able to consistently pick the winners.
There are only two ways that alpha can be generated, through stockpicking and market timing. Research suggests that these are very hard to get right and some would say impossible to achieve on a consistent basis. Yet despite the evidence, investors still find it hard to accept that the market return is good enough. This is a natural human reaction but is not rational or sensible.
Simple mathematics states that it is impossible for everyone to beat the market but most people like to think they are better than average, either at picking stocks or picking fund managers. Just remember that not everyone can be a winner and playing the game at all puts you at a natural disadvantage.
As we believe that markets are efficient, we would expect some funds to beat the market and some to underperform. Probability theory dictates that random distribution should have a small number of winners and a small number of losers, with most based around the average, that is, the market return. But all the evidence shows there are fewer winners than expected. This is due to costs which average well over 1.5 per cent a year for most active funds and skew the distribution so there are more losers than winners.
In our view, investors should focus their efforts on a core portfolio of index funds, keeping costs as low as possible. This should keep an investor ahead of the pack.
Jason Witcombe is a director of Evolve Financial Planning