In investing terms, “alpha” refers to the excess return that an investment generates compared to its benchmark index or the broader market. It is a measure of the investment’s performance relative to the market or a specific benchmark.
Alpha is often used by investors to assess the skill of a fund manager or investment strategy. If a fund generates positive alpha, it indicates that the manager has added value through active management and made investment decisions that resulted in returns higher than the market. On the other hand, negative alpha suggests that the investment performed worse than the market or benchmark, indicating that the manager’s decisions detracted from the fund’s performance.
Several types of Alphas
There are several different formulae used for calculating Alpha. Some use specific benchmarks while not adjusting for additional risk taken. At Spotalpha, we try to keep it simple, fair and easy to understand. Therefore, the calculation of Alpha that we use involves a straight forward comparison of the investment’s risk-adjusted returns to that of a benchmark in terms of a multiple.
Alpha = (Ri/MDDi) / (Rb/MDDb)
Ri = Percentage return of investment
MDDi = Percentage Maximum Drawdown or peak-trough fall of investment
Rb = Percentage return of benchmark
MDDb = Percentage Maximum Drawdown or peak-trough fall of benchmark
Here are some examples to illustrate how Alpha is calculated at Spotalpha.
Say, the index delivered 10% return and had a maximum drawdown (fall from peak-trough) of -10%.
Example 1: Your investment delivered 20% return and had a maximum drawdown of -10% during the same period. Then your portfolio’s alpha is 2X. I.e: it has outperformed the index by 2 times.
Example 2: Your investment delivered 20% return and had a maximum drawdown of -5% during the same period. Then your portfolio’s alpha is 4X. I.e: it has outperformed the index by 4 times.
Example 3: Your investment delivered 20% return and had a maximum drawdown of -40% during the same period. Then your portfolio’s alpha is 0.5X. I.e: it has underperformed the index and has only delivered half the return per same unit of risk.