In finance, alpha generation is the process of generating absolute returns, known as alpha, from capital funds and investments. An absolute return is usually thought of as a profit that defies known risks also adds gain without creating new risks. Generation itself is usually pretty easy to understand, but getting there can be a somewhat complex process, and is often aided by the use of computer algorithms and programs that can synthesize a lot of data at once and can make quick predictions based on past performances. Generators can be used both to analyze the financial health of a given portfolio and to make recommendations about purchases and acquisitions. They often give financial analysts insight on when to buy and when to sell, for instance. As with so many things related to the financial markets, though, little is certain, and things can change very quickly. Alpha generation can be predicted, in other words, but it can’t always be counted on.
Understanding Alpha
Alpha is often used as a way to measure the performance of a portfolio manager, with positive generation meaning that the manager created a portfolio that returned more than one would expect for its riskiness, and negative generation meaning that the manager created a portfolio that returned less than one would expect for its riskiness. Essentially, alpha allows one to compare the returns of portfolio managers while taking into account the risk that was assumed in order to achieve the returns.
Origins and History
First used by Michael Jensen in the 1970s, and sometimes referred to as Jensen's alpha, the variable was based on a derivation of the Capital Asset Pricing Model (CAPM). Under certain assumptions about the market, assets, and investors, CAPM posits that the expected return of a portfolio is equal to a base rate of return plus compensation for the risk of the portfolio. The base rate is the risk-free rate of return on an asset and, because the portfolio is assumed to be well-diversified, compensation for the risk comes entirely from the portfolio’s non-diversifiable, or market, risk. This is calculated as the product of the portfolio’s beta, or sensitivity to movements in the market, and the market premium, or expected return on the market minus the risk-free rate. Alpha is then the difference between the actual return and this expected return given by CAPM.
Calculation Basics
It is important to note that when calculating the alpha generation of a portfolio manager, one is implicitly assuming that CAPM is a valid asset pricing model. However, this particular model has been called into question in academic literature. Many critics have argued that its assumptions do not hold in the real world, among other things. For this reason, alternative asset pricing models, such as Arbitrage Pricing Theory (APT), have been put forth and are often used instead of or at least alongside standard alpha generators.
CAPM captures the risk of a portfolio based on its movement with the market. However, other risk factors have been shown to be important for explaining asset returns on a more empirical basis. Based on APT, the Fama-French three-factor model includes additional risk factors for size and book-to-market values. The concept of alpha generation can be extended to these models as well, as alpha simply remains the extent to which actual return exceeds or falls short of the predicted return.
Main Risk Factors
In practice, it is hard to consistently generate alpha, as to do so means to gain additional return without taking on additional risk in a market in which one is, in all likelihood, interacting with others who are trying to do the same thing. But due to the appeal of alpha, managers of hedge funds and mutual funds engage in, and will likely continue to engage in, the pursuit of alpha through a variety of strategies. Keeping the relative risks in mind is important, though, and not counting on success is one of the best ways to keep a positive balance no matter what. Many of the most profitable portfolios employ a wide variety of strategies simultaneously.