What Actually is Alpha?
I first came across the term ‘alpha’ in the mid-nineties. A trader from one of the convertibles trading teams told me he was very comfortable with his book (portfolio), as it contained a lot of ‘alpha’. I wished him well and then returned to my desk. When I looked through my trading reports, I too found a number at the bottom of the last page, my alpha.
Now the reason this little number had gone completely unnoticed, amongst countless other measures and symbols produced by the kind folks in our risk management departments, is that it doesn’t say much when it comes to making or losing money. You can ask any investment professional and they will almost certainly all agree that calculating alpha and predicting the future are entirely different things. Where we have massive differences of opinions though is, who is adding ‘alpha’, where and how much?
You see, by the time I moved out of banking after the dot com bubble, the term was everywhere and has been growing in popularity ever since. Everyone now ‘adds alpha’, every fund and investment manager, every advisor and consultant adds value in the name of some mathematical equation that very few people understand, and even fewer people know how to calculate. So, what actually is alpha in the context that we think? Very simply, it stands for adding value, which in trading terms means you make positive returns.
So far so good, but it’s not quite that simple after all. The reason that alpha was introduced on the trading floors is because you should try and make money every day – regardless of what happens in the markets. The banks wanted to distinguish those traders that could only make money when the markets went up from those that could when the markets went down. In other words, alpha is the excess return that remains once you subtract the market (beta) returns.
So, is beating a benchmark alpha? Well, since you can’t simply ‘subtract’ the market risk, you would need to actually hedge that risk of whatever benchmark you are trying to outperform. What good is it if the market is down 50% and you only lost 49%? Would you then be happy and maybe even pay the investment manager a performance fee on the 1% ‘gain’? Amazingly, a lot of people do, but that doesn’t mean we would. What we want is to extract the temporary mispricings of two relative and market neutral positions. We want to be able to close the positions, realise the profits in our accounts, bank the returns and move on to the next mispricing. Only then is it alpha!
Alpha is difficult to find, execute, and harvest. It also bears risks and is very complex on the operational side, requiring timely settlement, margining and execution management. There is also risk, covering a wide array of tangents, including legal and tax issues across jurisdictions and exchanges. In other words, alpha is complex, expensive and, when it works, the purest joy of all as you can tangibly show the value you have added.
Proceed with caution and remember, you can now buy the markets (beta) for as little as 0.10%, they tend to go up and have done so for hundreds of years. You don’t need to find someone to outperform the markets, you need someone who can give you alpha.