Alpha is one of the most common technical analysis ratios in the stock market. It depicts the absolute value at which the performance of a stock deviates from a benchmark index value.
Alpha in the stock market is widely used to track the active return generated by an investment, along with the degree of volatility of a stock.
Yield generated as a result of aggressive fund management by portfolio managers tend to be higher or lower than the average market performance (indicated by benchmark index values), and the difference between these represent the alpha value of a fund.
For example, an actively managed investment might generate a 10% return during a given period, whereas the benchmark index value during the same time yields returns at 8%. Consequently, alpha stocks can be calculated as 2% (10% – 8%) as it indicates the excess returns of a fund over its corresponding index value.
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Alpha in the stock market can be both positive and negative, depending upon the performance of the underlying securities. While a positive alpha means that a particular asset/portfolio has outperformed the market, a negative alpha value depicts a lower yield generated when compared to returns of a benchmark index.
In the case of passive index funds, portfolio returns equivalent to the fund yields lead to an alpha of zero.
Alpha stocks are usually depicted in percentage form, while some securities quote the value in numeric terms for most mutual funds and other portfolios. Actively managed funds can have an alpha of 1.5 or -2.60. While the former implies that the stipulated fund generated returns 1.5% higher than the market, an alpha of -2.6 means that portfolio yield was 2.6% less than index returns.
Capital Asset Pricing Model
Alpha is a primary component of the capital asset pricing model, developed to gauge the risk involved with an investment and, hence, its profitability.
All stock market investments have an inherent systematic risk due to the business cycle and socio-economic scenario. To minimize losses due to uncertain fluctuations, the exposure of a particular security to the market has to be assessed in line with the returns generated.
The capital asset pricing model is based on a principle that investors should only assume a higher risk if the returns adequately compensate for it. Alpha in the stock market implements this principle and is subsequently used by portfolio managers to assess the estimated returns to generate profits higher than the average stock market yield.
Technical Analysis Tools
Alpha is one of the most important technical analysis tools used by investors to determine the profitability of an investment, as it reflects an accurate risk-return ratio associated with a corpus. It is widely used in modern portfolio theory, along with Sharpe ratio, beta, standard deviation, and R-squared.
Modern portfolio theory aims to provide efficient investment strategies to a risk-averse investor to generate substantial returns through stock market tools, based on the assumption that given two portfolios having equivalent returns, individuals will invest in the fund having a lower degree of risk.
While alpha reflects the rate at which a fund outperformed the market, beta value depicts the volatility of underlying stocks. It helps investors gain a comprehensive idea about the risks and expected returns, and thereby helps them make an informed investment decision.
Jensen’s Alpha takes into account the risk associated with market-linked security.
The yield of an investment is compared to the interest accrued on a principal amount if invested in a risk-free non-market linked asset (e.g. fixed deposit). The beta value of an index is also considered while calculating Jensen’s alpha, as it accounts for the relative volatility of a stock with respect to a benchmark index.
It reflects an absolute yield accrued over time, based on which individuals can choose to invest in a stock.
Jensen’s Alpha = Actual return – [beta value x (return of index – risk free rate of return) + risk free rate of return]
Jensen’s alpha in the stock market can be demonstrated clearly with an example. Suppose, XYZ fund generated a return of 12%, while the corresponding index yield was 7% during the same period. Beta value of the stock was reported to be 1.5, while the risk-free return rate stood at 4%. Hence, alpha can be calculated as follows –
Jensen’s Alpha = 0.12 – [1.5 x (0.07 – 0.04) + 0.04]
Hence, the risk adjusted rate of return is 3.5%, while an active rate of return (standard alpha) is 5%.
Importance of Alpha
As stated above, the alpha stock meaning represents the monetary value added to a portfolio by a fund manager. Due to the economic boom and consequent market upswing, high returns are generated by most companies, leading to high index points.
During such times, small and mid-cap companies tend to outperform the market, thereby earning returns higher than the yield rate of blue-chip companies.
Portfolio managers having an aggressive investment strategy primarily procure shares of such funds, thereby having a positive alpha value.
The excess return percentage over market rates generated can be attributed to the tactics of portfolio managers.
Conversely, negative alpha values imply the poor performance of a particular fund even though the positive yield was generated through an investment strategy, due to inefficient fund allocation.
Limitations of Alpha
Alpha value contradicts the efficient market hypothesis, as it seeks to generate returns that are inconsistent with market performance. Additionally, statistics suggest that a fund generating relatively higher yields is unlikely to do so at a later date, as share prices fluctuate in tune with their performance and adjust accordingly to reflect their real value. To overcome this restriction, investors often use smart beta as an alternative technical analysis tool to incorporate passive investment strategies.
Alpha values are generally calculated using the benchmark index points of a particular sector, as it measures a company’s performance as compared to other competitor organizations. It also helps portfolio managers design a portfolio comprising multiple stocks of various companies to maximize the risk-return ratio.