Origin Of Alpha

By Author: Jamie Hanson
Total Articles: 3534
Comment this article

Alpha has not been around forever and it actually only came into existence during the middle of the 20th century because investment managers were not as successful as they should have been. That meant there was something else going on that investment managers were not taking into consideration with their investments. The answer was alpha. There were some academically inclined individuals who believed that the market was simply efficient and correcting itself since so many people were always watching and acting on the ups and downs of the market. The idea was that the manager of a fund or investment had little control of the random variations of the fund and no manager had an advantage over another when it came to making a fund money. This led to index funds that are market capitalization weighted to be created. Think about the S&P 500, which includes the 500 equities that are most widely held or the Wilshire 5000 that represents the largest securities.

All of this created a new thought process where investments are considered and what investment managers jobs really are. The idea that the investment manager should ...
... not only avoid losing money for his clients came into play in addition to the need for the manager to make the client a specific amount of money. The strategy of investing passively in everything equally lost its appeal and the idea of Alpha was born. This calculation shows the additional return, or additional loss, beyond the benchmark.

This has shown to be very important in the world of investments because now investment managers are able to determine when a specific risk pays off, and when it doesn't. Alpha is now used routinely in risk management to determine subsequent action on various investments. This statistical calculation is used in combination with beta, R Squared, and the Standard Deviation.

Alpha measures a portfolio's return that is in excess of the market return after both are adjusted for risk. Investors seeking higher alpha can consider long short mutual funds as part of their core portfolio holdings.