Financial Dictionary - Alpha (á)
Alpha is the best variable for measuring the performance of an investment fund manager. It measures the trading capabilities and skills of the manager and their team. This coefficient measures the performance or behaviour of an investment (positive or negative) compared to its benchmark index; in other words, it is the extra return obtained by the fund, after its fees.
The better the manager, the higher the alpha obtained by the fund. If the alpha is negative, i.e. there is no return, this means either that the manager did not choose the best securities for the fund or that they misallocated the weighting of these securities in their investment strategy for the fund.
Alpha is one of the five technical risk ratios in investing. The other variables in the formula are: Beta, standard deviation, R-squared and the Sharpe ratio. These are all the statistical variables used in trading. These indicators are intended to help investors determine the fund's risk or return profile.
How is alpha (á) calculated?
The alpha coefficient is calculated by subtracting the fund's average profitability or return from the average return on the index to which it belongs, based on the volatility of both factors, measured through beta, for the same time period.
A positive alpha of 1 means that the fund has returned 1% more than the market as a whole. This means the fund manager is adding value to the portfolio through their skills. An alpha of –1 means that the fund's performance was 1% lower than the performance of the market, meaning the manager and their team are underperforming the market.