What is 'Alpha'? | Freetrade Dictionary

The percentage by which an investor outperforms a relevant benchmark.

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.

Finding alpha

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 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 index tracking the 100 biggest publicly-listed companies in the UK 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.

More terms

Investment Trust

A company that pools money together from multiple investors and then invests it.

Fixed Income

An investment that provides a fixed rate of return, often over a specific set of time.

Diversification

An investment strategy in which money is put into a variety assets.

Time-Weighted Rate of Return (TWRR)

A return calculated over the time period invested, that excludes extraneous elements, such as deposits to and withdrawals from the investment accounted.