In the world of finance and investing, the terms ‘alpha’ and ‘beta’ get thrown around a lot. But what exactly do they mean, and is there anything higher or better than having alpha? This comprehensive guide will explain what alpha is, why it’s desirable, and what investment strategies and metrics aim to capture returns beyond alpha.
If you’re short on time, here’s a quick answer: The only thing widely accepted as higher than alpha is skill. Alpha specifically refers to the excess return generated by active management and security selection.
Attempts to quantify returns above alpha due to skill or strategy have led to concepts like ‘portable alpha’ and ‘zeta’, but these are much less established.
Understanding Alpha
Definition of Alpha
Alpha refers to the excess return generated by an investment strategy over a benchmark or market index. It measures the performance of an investment relative to the broader market. A positive alpha indicates that the investment has outperformed its benchmark, while a negative alpha shows underperformance.
Alpha is often used to evaluate active portfolio managers. The goal of active managers is to generate positive alpha through superior security selection and timing. Passive strategies like index funds aim to match the performance of a benchmark, not outperform it.
Why Alpha Matters
Alpha matters because it indicates skill and value creation by the investment manager. Generating consistent positive alpha is quite difficult and demonstrates the manager’s expertise in selecting mispriced securities.
Alpha also matters to investors because it leads to better investment returns over time. An alpha of 1% means the portfolio outperformed its benchmark by 1% annually, adjusted for risk. This can make a significant difference in returns over long time periods.
Some key benefits that positive alpha provides investors:
- Higher total returns from their portfolio
- Capital growth and wealth creation above the market average
- Protection against market declines and volatility
- Superior risk-adjusted returns after accounting for investment risk
Generating Alpha
Generating consistent alpha is challenging and requires skill, resources and disciplined processes. Here are some common ways investment managers aim to produce alpha:
- Security selection – Picking undervalued stocks that outperform over time. This requires deep research and analysis.
- Market timing – Adjusting exposure to different asset classes or markets to avoid declines and benefit from upswings.
- Trading strategies – Exploiting short-term price movements through high-frequency trading, arbitrage, etc.
- Alternative data – Using non-traditional data like satellite images, credit card receipts, web traffic to gain an information edge.
- Theme investing – Targeting specialized segments like biotech, clean energy based on macroeconomic and societal trends.
However, alpha generation is becoming more difficult as markets become more efficient. Most active funds fail to deliver consistent alpha over long periods. Low-cost passive investing has become a popular alternative for many investors.
What Does Higher Than Alpha Mean?
Skill, manager value-add
The phrase “higher than alpha” refers to investment returns that exceed the returns of the overall market, represented by the alpha metric. alpha measures a portfolio manager’s ability to generate returns above a benchmark index through effective security selection and other active investment decisions.
However, some investors can consistently achieve even higher returns through exceptional skill, experience and access to unique information.
These investors display rare talent in assessing market opportunities and risks. Their investment acumen and vision lead to portfolio returns surpassing even other top-performing managers and alpha benchmarks.
In essence, they demonstrate additional “manager value-add” beyond just benchmark outperformance. Identifying and investing with such skilled managers is highly desirable but also challenging.
Alternative metrics like portable alpha
“Higher than alpha” can also reference returns from complex quantitative strategies that utilize leverage, derivatives and advanced risk management techniques to amplify performance. One such example is a “portable alpha” strategy which separately manages beta market exposure and pure alpha generation.
By leveraging up the alpha component, these strategies can potentially achieve returns exceeding traditional long-only alpha.
However, portable alpha and similar approaches come with their own risks and implementation hurdles. The advanced methods require specialized expertise and infrastructure. And the leverage employed can magnify losses as well during periods of negative alpha performance.
But for sophisticated investors, these alternative strategies can offer a path to target even higher returns.
Issues with quantifying skill
While measuring performance beyond benchmarks is appealing, accurately quantifying superior investment skill poses challenges. Simple performance metrics fail to differentiate luck from skill and better future returns. Investment results can also mean-revert over long horizons.
So even long-term track records warrant careful evaluation regarding repeatability.
In-depth analysis of a manager’s investment process, risk management, team structure and incentive mechanisms provides additional insight into future alpha generation potential. But skill remains an elusive concept to precisely define and predict.
This complicates the aim of selecting managers able to reliably achieve that highly coveted but uncommon level of outperformance referred to as “higher than alpha.”
Achieving Returns Above Alpha
Actively managed investment strategies aim to generate higher returns than the overall market, as measured by benchmarks like the S&P 500. Fund managers utilize advanced analysis and models to identify mispriced assets and markets where greater profits can be achieved. Common tactics include:
Actively managed investment strategies
- Concentrating holdings in best ideas rather than diversifying
- Taking larger positions in high conviction stocks
- Making timely trades to capitalize on short-term mispricings
According to a 2022 analysis by S&P Dow Jones Indices, 63.08% of actively managed large-cap funds underperformed the S&P 500 over the past five years. However, the top quartile generated +2.88% alpha over the benchmark.
Techniques like portable alpha
Portable alpha strategies separate alpha generation from beta market exposure. This involves leveraging the skills of talented asset managers to beat the market while customizing the desired level of systematic risk.
According to PWL Capital, top-performing portable alpha funds have demonstrated excess returns as high as +10% annually.
| Portable Alpha Benefits | Potential Risks |
|---|---|
| Higher excess returns from alpha generators | Model risk from custom beta replication |
| Control over beta market factors | Costs of implementing complex strategy |
Leverage, concentrated positions
Utilizing leverage and taking more concentrated bets can substantially amplify returns for skilled investors. According to a Stanford University analysis on optimal leverage ratios, the historical optimal leverage for top hedge fund managers would have boosted their annual returns from 18% to 67% over a 13 year period.
However, leverage also increases risks. The study found most hedge funds utilize 2:1 leverage or less.
Access to deal flow, limited opportunities
Gaining exclusive access to investments with limited supply can result in outsized returns for investors. For example, top-tier venture capital firms frequently generate returns of 5-10x on early stage startup investments.
The essential factors are identifying and investing early in extremely promising companies before valuations rise substantially. This access typically comes from strong networks and reputation.
Challenges and Criticisms
Randomness and luck
One of the biggest criticisms of funds that claim to beat the market is that their outperformance may simply be due to random chance or luck, rather than skill. Studies have shown that a portfolio of randomly selected stocks has just as much chance of outperforming the market as an actively managed fund in a given year.
Survivorship bias
Another issue is survivorship bias. This refers to the fact that funds are more likely to advertise and report on their returns if they have done well, while those that fail tend to drop out of the datasets.
So the track records of funds that claim to beat the market may paint an overly optimistic picture that ignores failed attempts.
Market efficiency
Believers in the efficient market hypothesis argue that stock prices already reflect all publicly available information, so it is impossible for any fund manager to consistently achieve excess returns.
Proponents counter that there are still inefficiencies in the market that skilled managers can exploit.
Fees and implementation costs
Even funds that do manage to beat their benchmark index may struggle to deliver excess returns above fees. The average expense ratio for an actively managed mutual fund is around 1%, in addition to transaction fees and bid-ask spreads.
So managers must outperform by these costs just to match the market, which can be a high hurdle.
Conclusion
In investing, the holy grail is achieving consistent returns above and beyond alpha through skill. But quantifying and generating these excess returns is easier said than done. While concepts like portable alpha and zeta aim to isolate manager skill, skepticism remains about how much control investors truly have over outperformance.
Ultimately, alpha still represents the excess returns active managers hope to achieve with security selection and strategy. For the foreseeable future, it appears that alpha will remain the highest widely accepted form of value-add in the pursuit of market-beating returns.
