What is Alpha? And How Do I Get It?

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Alpha is usually shown deep within a mutual fund prospectus if that fund is an underperformer and is usually featured prominently when a fund is doing well.

What is it?

Simply put, Alpha it the amount that a particular fund out performs its benchmark index.

For instance. If a certain mutual fund’s stated benchmark is the S&P 500 and the S&P earns 10% in a particular year and your fund earns 15%, the fund’s Alpha would be 5%. 

Alpha is what every investor seeks. It is reflective of a money manager’s skill relative to the market. If you are paying someone to manage funds for you you would want that fellow to at least out perform the sated benchmark which you could invest in for virtually nothing. A fund manager’s job is to create Alpha. If he can’t do that, then why pay him?

It is important to note that a fund need not be in positive territory for a money manager to be doing a good job. Indeed 2008 saw only one US focused large cap fund earn a positive return. This out of thousands. But a good number of fund managers still beat their benchmarks. Unfortunately the benchmarks were down 40%. So if you were down only 30% in your fund in 2008, congratulations you beat the market by 10%! Cold comfort I know, but it’s still a significant accomplishment.

One of the problems with Alpha is how illusive it is. Very few money managers consistently earn Alpha. A manager might have a lucky streak and beat his benchmarks for a couple of years, but more times than not, that fund will revert back to the mean. That is to say it will come more in line with its benchmark, or worse.

A surprising number of Alpha seeking mutual funds consistently fail to even match the index they are trying to beat. About 70% year in and year out in fact. Keep this in mind when you buy an expensive mutual fund managed by the “rock star” manager of the moment.

Alpha’s what you want. It’s what investing is all about. But it’s really hard to obtain year in and year out. Especially if you are paying yearly fees to a fund manager.

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