Alpha is one of those words that’s thrown around a lot by finance nerds, often in an effort to make themselves seem more grandiose than they really are.
It’s a percentage that expresses by how much a given investment did (or did not) outperform a benchmark figure. And if that sounds too finance-y for you, we’ll explain.
Benchmarks in the financial world are often used as a means of gauging how successful a particular investment has been. A quick example illustrates this.
Let’s say that an imaginary company called Bank X was investing in the UK stock market.
We could take the FTSE 100 - an index of the 100 biggest publicly-listed companies in the UK - and use it as a benchmark to compare with Bank X’s investments.
Now let’s say that over a period of five years:
Bank X’s investments increased in value by 10 per cent
The FTSE 100 increased in value by 6 per cent
We calculate Alpha by subtracting the benchmark percentage increase from the investment percentage increase. In our case that means;
10 - 6 = 4
Alpha = 4 per cent
Why do investors use alpha?
One of the biggest debates in the investing world today is whether passive or active investing is superior.
Passive investing is where people put their money into a fund, often an ETF, that tracks a particular index. This gives them exposure to the market as a whole.
Active investing is where people pick individual stocks in the hope that they’ll generate more money than the market can.
And that’s really where alpha comes into play.
Given that investors can now put their money into index-tracking funds, someone’s ability to generate alpha carries a lot of weight. After all, if you cannot outperform an index, there isn’t much point in doing any active investment.
And though outperforming may not sound too hard, it’s not something that many companies can do. In fact, from 2007 to 2017, only 17 per cent of US active investment funds were able to outperform their benchmarks.
It’s for that reason that alpha is often described as the ‘Holy Grail’ of investment - desperately desired but very hard to find.