Alpha (Financial Analysis) - Explained
What does Alpha represent in Financial Analysis?
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Table of ContentsWhat does Alpha Represent?How to Use Alpha in Economic AnalysisAcademics Research on Alpha
What does Alpha Represent?
Alpha is a term that measures the active return of an investment, it is the excess return or abnormal return that an investment yields. Alpha gauges the ability of an investment to outperform the market or beat its edge. It measures the performance of a strategy in beating the return in the market. Alpha is also known as the active return on an investment, it is represented by symbol (a greek letter). Alpha can be positive or negative, it refers to an investment's return relative to the return of the market index or benchmark. Investments such as mutual funds or bonds are ranked using the alpha. Alpha measures the performance of a portfolio in comparison to the benchmark index in the market.
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How to Use Alpha in Economic Analysis
There are many metrics used in the market to evaluate the risk and return of an investment. Alpha is one of the tencinal risk-return metrics used in the modern portfolio theory (MPT), portfolio managers seek to generate alpha in investments, portfolios and assets they manage. Aside from apla, other technical risk ratios are beta, R-squared, Sharpe ratio and standard deviation. Alpha measures the performance of an investment or diversified portfolio relative to the market benchmark. An alpha of zero indicates that the investment has not made any significant return neither has it made any loss in the market. Active portfolio managers often aim to generate investment returns that beat that of the benchmark in the market, they track the performance of their investment using the Alpha. However, it is often difficult for these asset managers to beat the market benchmark. Historical record and past evidence reveal that it is difficult for active mutual funds to have an alpha higher than that of the benchmark in the market. According to historical records, less than 10% of active funds have been able to earn an alpha higher than the benchmark, using a time frame of 10 years.