What does Alpha mean?

If the S&P 500 index of a stock stays the same during a year period, a measurement named alpha can be calculated, which is a specific stock’s average move per month.

a. Alpha is basically a measure of performance on a basis adjusted no risks. Taking the volatile nature of mutual funds, also known as the price risk, the alpha compares their risk adjusted performances to a benchmark index. The fund’s alpha is actually the excess return of the mutual fund relative to the benchmark index’s return. The alpha is a technical risk ratio; there are five in total: beta, the Sharpe ratio, R-squared, and standard deviation. These technical risks are statistical measurements applied in what is called MPT, or modern portfolio theory. These indicators are all intended to facilitate in determining the risk reward profile of a fund for investors.

Alpha represents the value that portfolio managers add to or subtract from a mutual fund’s return. For instance, if the alpha is positive, say 1.0, then it means that the mutual fund is doing well and it has surpassed its index by 1 percent. To the same effect, if the alpha is -1.0 then this mean the fund has not performed as expected and has dropped by 1 percent.

b. Alpha can also mean the abnormal rate of returns on securities or portfolios in excess of what would normally be predicted by a reference or equilibrium model, for instance the capital asset pricing model or CAPM for short.

If a capital asset pricing model analysis makes an estimation that a portfolio is supposed to earn 10 percent based on its own risk, meanwhile it earns 15 percent, this means that the portfolio’s alpha is calculated to be 5 percent. This number is actually the excess return above the estimate predicted by the capital asset pricing model.