Potential Problems With Alpha

By Author: Jamie Hanson
Total Articles: 3495
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While alpha is a wonderful calculation that allows investment managers to determine whether or not a specific risk was worthwhile, there are some potential problems. Before using alpha to help manage risk in your portfolio make sure you understand its limitations and any potential problems that could crop up. The following issues are noteworthy and can be worked around if you know what they are.

Can't Be Used Alone
Alpha can't be used alone to determine whether a fund is performing well. Alpha simply shows whether a calculated risk allowed the fund to perform over its benchmark or below it. When used alone alpha does not show the risks associated with volatility in the market. That's why alpha should only be used in conjunction with other important calculations like standard deviation, R Squared, and Beta.

Might not be Accurate
Another potential problem with alpha is it might not be accurate. Some funds may even have several different alphas calculated and in this scenario it is important to know which is most accurate. Generally, when the R Squared number is close to 100 the alpha is most accurate. ...
... When you find a fund where different companies have calculated different alphas always check the R Squared number for accuracy.

Application
Another potential problem with alpha is application. While it might look pretty easy at first, using alpha in conjunction with the other statistical calculations can be quite complicated. As a result, you will want to feel very confident in your knowledge and application skills before you begin using this for risk management purposes in your portfolio.

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.