In investing, alpha (α) refers to the return on investment beyond the expected rate of return. Also called the active return, this is often attributed to an investment manager’s skill, being the result of active management rather than market conditions.
The benchmark used for alpha valuation is calculated using a capital asset pricing model (CAPM), which projects the potential returns of an investment portfolio. Alpha is then calculated using:
Alpha = (End Price + Distribution per Share – Start Price) / Start Price
Alpha is typically denoted as a number referring to the percentage points above or below the benchmark (+2.0 indicates returns 2% higher, while -4.0 indicates returns 4% lower). An alpha of 0 would indicate a portfolio performing in line with the benchmark index, lacking any additional value from a portfolio manager. Investors should be wary of fees when choosing advisors, as a return with an alpha of 0 is a net loss for the investor after fees. Similarly, when fees exceed positive returns, investors also earn less than the normal market rate.
Alpha and Beta
Alpha and beta (β) are both measures of past performance as well as being technical investment risk ratios, with other popular metrics being R Squared, standard deviation, and the Sharpe ratio. All five indicators are used in Modern Portfolio Theory and in determining the risk-return profile of a portfolio.
While alpha examines the active return of a portfolio, beta accounts for systematic market risk and volatility. Alpha indicates how well an investment has performed in relation to the benchmark market index, while beta indicates how volatile an investment is compared to the overall market.
Beta is used by investors when deciding if an investment’s volatility is worth its risk. With a baseline of 1 indicating a correlation directly with the market, less than 1 has a relatively nonvolatile price and greater than 1 is a relatively volatile investment.
Beta= Covariance of Asset’s Return with Market’s Return / Variance of Market’s Return
Alpha in Real Estate
While commonly used in evaluating stocks, this concept is extensible to real estate investing as well. At a portfolio level, diversification is key to generating outsized returns, as it balances risk, and a real estate allocation can provide this diversification into alternative assets. At an individual investment level, savvy investors can generate alpha through skilled asset management.
Returns for private, illiquid real estate depend on skill in asset management and discovering value that stems from market inefficiencies: entering into a market or submarket that is undervalued; acquiring a property at below-market value; leveraging superior scale and operational capability to update multi-unit properties and bring rents to market rate; introducing new amenities or technology; or some combination thereof.
Additionally, values of private real estate assets tend to be less responsive to market shocks (particularly in certain real estate asset classes, like self-storage or industrial). In other words, private-market real estate carries a greater potential for achieving alpha and entails a lower degree of systematic risk than is generally observed in public asset markets.
The Bottom Line
In short, alpha is a measurement of an investment that has managed to beat the market return over some period, compared against a benchmark of performance and as the result of a particular strategy, trader, or portfolio manager.Back to Glossary