Alpha
As discussed above, alpha is a measure of how much better a portfolio of securities performs than what could be expected from the market. A portfolio’s alpha is typically used to evaluate a fund manager’s performance. An alpha of 2% means that the manager was able to add 2 percentage points more to the portfolio return than what would be expected if the fund was not actively managed. An alpha of -3% means that the manager actually cost the portfolio 3% compared to the benchmarks it is measured against. To calculate alpha, subtract the expected return of a portfolio from its actual return. When one is using alpha to evaluate a portfolio, expected returns for each stock are often calculated using the stock’s beta or the capital asset pricing model.
alpha = portfolio’s actual return – portfolio’s expected return
Example Question 1
A