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Alpha

1. A measure of a mutual fund's risk relative to the market. The formula for alpha is the following:

[ (sum of y) - ((b)(sum of x)) ] / n

Where:
n = number of observations (36 mos.)
b = beta of the fund
x = rate of return for the market
y = rate of return for the fund

2. The abnormal rate of return on a security or portfolio in excess of what would be predicted by an equilibrium model like the Capital Asset Pricing Model (CAPM).

Notes:

1. An alpha of 1.0 means the fund outperformed the market 1.0%. A positive alpha is the extra return awarded to the investor for taking additional risk rather than accepting the market return.

2. If a CAPM analysis estimates that a portfolio should earn 10% based on the risk of the portfolio but the portfolio actually earns 15%, then the alpha of the portfolio would be 5%. This 5% is the excess return over what was predicted in the CAPM model.

See also: Beta, CAPM, Jensen's Alpha, Mutual Fund, Weighted Alpha

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Alpha

Measure of risk-adjusted performance. An alpha is usually generated by regressing the security or mutual fund's excess return on the S&P 500 excess return. The beta adjusts for the risk (the slope coefficient). The alpha is the intercept. Example: Suppose the mutual fund has a return of 25%, and the short-term interest rate is 5% (excess return is 20%). During the same time the market excess return is 9%. Suppose the beta of the mutual fund is 2.0 (twice as risky as the S&P 500). The expected excess return given the risk is 2 x 9%=18%. The actual excess return is 20%. Hence, the alpha is 2% or 200 basis points. Alpha is also known as the Jensen Index. Related: Risk-adjusted return.

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alpha

The mathematical estimate of the return on a security when the market return as a whole is zero. Alpha is derived from a in the formula R_i = a + bR_m which measures the return on a security (R_i) for a given return on the market (R_m) where b is beta. See also capital-asset pricing model (CAPM), characteristic line.