Alpha is an important trading indicator which measures the performance of a fund or security or portfolio with respect to a benchmark or predicted return and to the risk taken. Simply, alpha is the difference between the actual performance and expected performance. Positive alpha means the fund/portfolio outperformed the benchmark, negative alpha means the same underperformed the benchmark and a value of zero means that it performed as expected.
Where Rp is the total portfolio/security/fund return, B is the beta value of the security, Rb is the total benchmark/expected return and n is the number of observations.
Alpha indicator is considered as a measurement indicator of the investor’s or fund manager’s stock/investment screening ability. Often investment models like capital asset pricing model or CAPM and Three factor model are used to calculate the expected return from a portfolio or security with respect to the risk taken; high risk investments should offer high returns. If the actual performance beats this expected value, then the fund manager or investor has added to the return. For example if CAPM estimates a 10% return from the portfolio but the actual return is 15%, then the portfolio outperformed the benchmark by 5%.
Alpha indicator is considered one among the five important technicals of a fund’s performance; others include beta indicator, standard deviation, Sharpe ratio and R-squared indicator. There are some other variations of alpha indicator like Jenson alpha which is used to get custom or more accurate results.
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