Alpha/Beta Separation

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Alpha is a measure of the active return on an investmentthe performance of that investment compared alpha beta finance definition a suitable market index. Alpha, along with betais one of two key coefficients in the capital asset pricing model used in modern portfolio theory and is closely related to other important quantities such as standard deviationR-squared and the Sharpe ratio. In modern financial markets, where index funds are widely available for purchase, alpha is commonly used to judge the performance of mutual funds and similar investments.

As these funds include various fees normally expressed in percent terms, the fund has to maintain an alpha greater than its fees in order to provide positive gains compared with an index fund. Historically, the vast majority of traditional funds have had negative alphas, which has led to a flight of capital to index funds and non-traditional hedge funds. It is also possible to analyze a portfolio of investments and calculate a theoretical performance, most commonly using the capital asset pricing model CAPM.

Returns on that portfolio can be compared with the theoretical returns, in which case the measure is known as Jensen's alpha. This is useful for non-traditional or highly focused funds, where a single stock index might not be representative of the investment's holdings.

It is the intercept of the security characteristic line SCLthat is, the coefficient of the constant in a market model regression. It can be shown that in an efficient marketthe expected value of the alpha coefficient is zero.

Therefore, the alpha coefficient indicates how an investment has performed after accounting for the risk it involved:. In this context, because returns are being compared with the theoretical return of CAPM and not to a market index, it would be more accurate to use the term of Jensen's alpha.

A belief in efficient markets spawned the creation of market alpha beta finance definition weighted index funds that seek to replicate the performance of investing in an entire market in the weights that each alpha beta finance definition the equity securities comprises in the overall market.

In fact, to many investors, [ citation needed ] this phenomenon created a new standard of performance that alpha beta finance definition be matched: The name for the additional return above the expected return of the beta adjusted return of the market is called "Alpha".

Besides an investment manager simply making more money than a passive strategy, there is another issue: The passive strategy appeared to generate the market-beating return over periods of 10 years or more. This strategy may be risky for those who feel they might need to withdraw their money before a year holding period, for example.

Thus investment managers who employ a strategy alpha beta finance definition is less likely to lose money in a particular year are often chosen by those investors who feel that they might need alpha beta finance definition withdraw their money sooner.

Investors can use both alpha and beta to judge a manager's performance. If the manager has had a high alpha, but also a high beta, investors might not find that acceptable, because of the chance they might have to withdraw their money when the investment is doing poorly. From Wikipedia, the free encyclopedia. For other uses, see Alpha disambiguation. This article needs additional citations for verification.

Please help improve this article by adding citations to reliable sources. Unsourced material may be challenged and removed. March Learn how and when to remove this template message. Primary market Secondary alpha beta finance definition Third market Fourth market. Common stock Golden share Preferred stock Restricted stock Tracking stock. Authorised capital Issued shares Shares outstanding Treasury stock. Electronic communication network List of stock exchanges Trading hours Multilateral trading facility Over-the-counter.

Alpha Arbitrage pricing theory Alpha beta finance definition Bid—ask spread Book value Capital asset pricing model Capital market line Dividend alpha beta finance definition model Alpha beta finance definition yield Earnings per share Earnings alpha beta finance definition Net asset value Security characteristic line Security market line T-model.

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