What is Alpha?
Alpha is a calculation that determines a portfolio's performance relative to a benchmark index. If the portfolio outperforms the benchmark index, the portfolio has positive alpha. Conversely, if a portfolio underperforms the benchmark index, the portfolio has negative alpha.
It is common to compare a portfolio's performance to a benchmark index structured similarly to the portfolio. For instance, the performance of a portfolio comprised of large cap US equities would likely be compared to the performance of the Dow Jones Industrial Average. The performance of a portfolio made up of US corporate bonds would compare against a bond index such as the Dow Jones Corporate Bond Index. The performance of a portfolio made up of global equities would likely be compared against the MSCI EAFE (Europe, Australasia and Far East) Index.
For an individual investor, it is more useful to compare portfolio returns to an ETF that tracks the market, because an ETF is a viable alternative investment. An investor cannot invest in the S&P500, but an investor can invest in the SPDR S&P 500 ETF (SPY), an ETF designed to track the S&P 500. An investor cannot invest in the Dow Jones Corporate Bond Index, but they can invest in the iShares Investment Grade Corporate Bond Fund (LQD). An investor cannot invest in EAFE, but they can invest in the iShares MSCI EAFE Index Fund (EFA).
Benefits of alpha
Measuring the alpha of one's portfolio lets an investors know whether they, or their fund managers, are doing well relative to their peers. When choosing which fund to invest in, an investor can compare the alphas of various funds. After purchasing units in a fund, an investor can track that fund's alpha going forward, and use the results as a determinant in whether they will stay invested in that fund or choose to deploy their funds elsewhere. Likewise, individual investors can determine whether they are adding any value to their portfolio by picking individual stocks. If a stock picker is not beating the index, perhaps they would be better served by purchasing an ETF that tracks the benchmark they were trying to beat.
Disadvantages of alpha
There are two deficiencies with benchmarking alpha to a comparable index:
- In aggregate, this does not provide any information about the effect of your asset allocation.
- Outperforming the benchmark index in a bad year can lead to an inflated view of one's portfolio performance.
Benchmarking alpha to an index comparable to your investments provides insight as to whether you, or your fund manager, is better than average at picking investments within that sector of your portfolio. In aggregate, this does not provide any information about the effect of your asset allocation. In a bear market, it's better to have a greater allocation to bonds, in a bull market, it's better to have a greater allocation in stocks. Benchmarking both portions of your portfolio against their relative indices will not provide any information regarding the effectiveness of your asset allocation.
Outperforming the benchmark index in a bad year can lead to an inflated view of a portfolio's performance. For example, let's say an investor is bullish on the American economy in late 2007, and invests his entire portfolio in a basket of American stocks. The investor calculates his alpha by using a benchmark of SPY, which closed on December 31, 2007 at 146.21. Over the next year, it lost 38.28% of its value to close at 90.24 on December 31, 2008. Let's say our investor was shrewd in his stock selection, and outperformed SPY by 10 points. Our investor would have lost 28.28% of his portfolio value, but could take some solace that he beat the index by 10 points.
If the investor were to calculate his real return, that is to compare his performance to inflation, the results would be devastating. According to the U.S. Department of Labor, the US Consumer Price Index increased from 207.342 to 215.303 in 2008, a percentage increase of 3.84%. While our investor can take solace in the fact that he beat the market by 10 points, when compared to inflation, his portfolio lost 32.12 points. In real terms, the purchasing power of his investment declined by one third. This can get especially painful if the 10 point outperformance was achieved through a fund that charges fees as a percentage of the outperformance of the benchmark.
This is an extreme example, given that 2008 was one of the worst bear markets in history. Over time, investment in equities has outpaced inflation by a significant margin. When investing in equities, it is easier to outpace inflation rather than a stock market index over the long term. In years when stocks decline, it is easy to justify a poor performance when benchmarking to a comparable index.
Inflation as a benchmark for aggregate portfolio alpha
I don't invest with the intention of generating greater returns than a comparable investment. I invest to increase the purchasing power of my assets; I want my money to work for me. I don't think my goals are different from the average investor; is an investor more concerned with increasing their purchasing power or in beating an index?
When investing for the long-term, it is important to be cognizant of the big picture. My big picture goal is bigger than how my stocks perform, it is bigger than how my bonds perform, and it is bigger than how my real estate investments perform. The big picture goal for me involves my money compounding at a greater rate than inflation, so that my assets increase their purchasing power, providing me with the ability to afford a better life. While I want the different sectors of my portfolio to beat their relative indices, I am more concerned with overall portfolio returns, in particular their performance relative to inflation.
I encourage you to continue evaluating your investments relative to a comparable index. They are but one tool amongst many to determine how well your investments are doing. But I also encourage you to be cognizant of your portfolio returns relative to inflation. By benchmarking your portfolio alpha to inflation, you are calculating your real return.