Alpha is an investing performance measure that tracks the return of a position or portfolio relative to some representative benchmark.
For example, the benchmark for a portfolio of U.S. equities may be the S&P 500, and any return above or below that of the S&P 500 for that year would be considered the portfolio’s alpha (it can be either positive, negative or neutral).
Alpha Example
Imagine that an investment management company maintains a global emerging market bond fund that invests in government bonds from emerging markets.
The benchmark for this fund would be some global index of emerging market government bonds. Alternatively, if such a simple benchmark did not exist, then the benchmark could be constructed using the average performance of similar funds.
If the performance of the bond fund was 8% and the performance of the benchmark was 5%, then the alpha for that period would be 3%.
The Importance of Alpha
The concept of alpha is a critical issue in the contemporary financial world.
It was once the goal of every investment manager, with hedge funds being considered the titans of the investing world for their ability to regularly outperform standard equity benchmarks.
However, over the last few decades the rise of automated and computer-enhanced investment strategies have largely weeded out the once many market inefficiencies that investment managers exploited to achieve high-alpha returns.
Now many in the investing world are questioning whether alpha is a worthy goal, as alpha-seeking funds continue to underperform the market as a whole.
As investment managers consistently fail to deliver positive alpha under the new state of the markets, an increasing number of investors are turning to simple benchmark trackers that do not attempt to outperform the market to generate positive alpha, but rather simply mimic the movements of the market as a whole.
This cultural shift has led to a significant decline in the demand for the services of investment managers and led to a diversification of performance-seeking strategies, such as the more widespread use of venture capital and private equity in contemporary portfolios.
Therefore, it does not carry the same positive connotations in contemporary financial culture that it once did. Some commentators suggest that the rise of passive investing will lead to a corresponding re-emergence of the market inefficiencies that drive positive alpha, but this outcome remains to be seen.
Alpha and Trading
Day traders do not generally measure themselves against a benchmark, as their goals on a relative basis are far more aggressive due to the smaller absolute returns that they aim to achieve.
Investment managers deal in extremely large sums that are orders of magnitude larger than the funds that the typical day trader will manage.
This means that the strategies that investment managers employ are limited when compared to those that a day trader can use. Therefore, investment managers are generally trading with the market as whole, while day traders can trade nimbly and completely divorced from the overall direction of the markets.
Day traders tend to produce large amounts of alpha in any successful trades that they make.
For example, a week-long increase of 3% in a stock could see a successful day trader profit many times over 3%, as they trade on the volatility surrounding this week-long 3% increase, particularly if the day trader is using leverage to enhance any gains made.
However, this is different from the traditional sense of the word alpha, which refers directly to some relative performance compared to a representative benchmark.
Final Thoughts
The concept of alpha is not particularly useful for creating effective trading strategies, unlike its sister concept beta. Rather, alpha is useful for understanding the actions and motivations of market actors, and the general state of contemporary markets featuring the rapid rise of passive investing.
Day traders should stay abreast of these discussions concerning passive investing and investment management performance, and the corresponding rise and fall of market inefficiencies, as they will color the broad strokes of the investing world for the next decade at least.
Understanding how market behavior is changing is key to maintaining fresh and effective trading strategies, as well as keeping yourself ‘in the know’, which is such a critical element to maintaining a positive attitude toward trading.