Basics Of Alpha Revisited ... For The Investor - Part 1

Includes: DIA, IWM, SPY
by: Braun Research

Everybody and his dog in the investment business talks about and seeks "Alpha." So much so that a very popular and, I would say, quite interesting on-line magazine, of which you may have heard, elected to call itself exactly that: " Seeking Alpha."

But if you were to ask most investors, even professionals, to tell you what this blasted "Alpha" exactly is, beyond being told that it is spelling out the Greek letter "α" you will most likely get a diversity of answers, not to mention the blank that you may draw in some cases. So what is Alpha and what does it tell us about a portfolio manager?

To begin with, among many other definitions found in various places, a simple one, which I happened to find on INVESTOPEDIA defines it as follows:

"The excess return of the fund relative to the return of the benchmark index is a fund's Alpha."

But what does this really mean? Don't we all want to have as much return as possible? Is this definition implying that by achieving a high Alpha your return may be "excessive"? Not a nice thing to be "excessive" in whatever you do or acquire, is it? Well, the definition does not mean or even imply anything of the kind. It is just academic lingo for describing the fact that a return that is better than that of some mechanically and thoughtlessly defined portfolio of reference, like an index [S&P500 (NYSEARCA:SPY), Russell 2000 (NYSEARCA:IWM), Dow Jones (NYSEARCA:DIA), some sector or commodity index, etc.], has been delivered to you in exchange for the often hefty fee that you pay the portfolio manager (PM) and his firm. Mind, I do not mean here that there is no thinking involved in constructing an index. It is in fact a difficult, costly and arduous process, with very bright and often highly educated people toiling at it. It is just not the kind of intellectual effort related to your making more money that you expect from your PM. But it is rather the non-trivial attempt to describe as exactly and as unemotionally as possible a certain market, so that a PM who is supposed to offer the investor some value, cannot claim good performance simply because s/he (or you as an investor) happened to decide to invest in that market. Therefore, what this definition really tells us is that Alpha is the very important measure of what a PM is delivering to the client for the fee charged.

Because Alpha is so important, I thought that elaborating a little about what Alpha really is, how it is measured and how it should be measured from an investor's point of view, without all the academic gobbledygook that one finds when attempting to research the subject, might be in order.

Take a look at this graph and tell me which of the two portfolios appears to you to be more rewarding, the "Steady" or the "High-Flier"?

Most people will select the High-Flyer... and they will be wrong. In order to understand why, take a look at the numbers behind the chart - (click to enlarge):

The start-to-finish performance for both portfolios is the same 30% and both exceed the benchmark by the same 5.39%. Many would say that the 1.67% is the "Alpha"… But it is not: this only measures the performance between the starting point and the end point, with no regard whatever to what happened in-between. That is terribly wrong: the 1.67% is only the compounded average periodic outperformance, NOT an Alpha. The periods can be years, months, weeks days or minutes; it makes no difference.

So is there a difference between the two portfolios from an investor's point of view? There sure is: the difference is the Alpha!

The Steady portfolio reached its performance by growing more or less steadily… that's why we called it "Steady." It does not show huge fluctuations in performance; whereas the High-Flyer had two periods of very negative performance in the beginning and was only able to make it all up in the last period. This means that the manager of the High-Flyer is more prone to taking higher risks than the manager of Steady. Which of the two would you be more confident to invest with in the future? What if High-Flyer would not have had that tremendous performance (may be luck?) in the last period? What if you needed your money after the 4th period? You would have been forced to miss the last run-up and would have ended up with a loss of 10% (being left with $900 from a starting $1,000) instead of the 30% gain.

Continue to Part 2

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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