Alpha measures the performance of an investment in comparison to a benchmark index

• Alpha is a financial metric that shows how an investment performs relative to a benchmark index.
• An investment that has positive alpha is outperforming the index.
• Alpha is one of five risk ratios investors can use to build a risk-adjusted portfolio.

Passive investing is a popular long-term approach that generally involves buying and holding a mix of index funds. The goal is to minimize your fees while matching the overall market's returns. But some investors take a different approach. Rather than matching the market, they try to earn more - or generate alpha.

What is alpha?

Alpha (α) is a financial metric that investors and portfolio managers can use to compare the performance of an investment to a related benchmark. It can help tell you if an actively managed portfolio or fund is "beating the market." But the basic alpha formula doesn't account for the risk you're taking.

"Alpha, in its most basic definition, is the relative return to the benchmark," says Amir Noor, director of financial planning at United Financial Planning Group.

For example, the S&P 500 is a broad stock market index that tracks the 500 largest public companies in the US. It sometimes stands in for how the stock market is doing in general, which is why some people may say the market is rising or falling as the S&P 500 changes.

"If you're a portfolio manager and you're benchmarking to the S&P 500. If you returned 11% and the S&P returned 10%, your alpha is one," says Noor. Conversely, an investment can have a negative alpha if it performs worse than its benchmark over a specific period.

Understanding how alpha works

Alpha corresponds with a benchmark and is used to measure the performance of actively managed investments.

Many people invest in index funds, which are passive funds that track a corresponding index (the S&P 500 or another one). "The alpha will be zero if it is an index fund," says Noor. Instead of trying to beat the market, you're investing with the intent of getting market returns.

An investor or fund manager who wants to produce alpha will try to actively buy and sell investments to earn a greater return than the benchmark index. However, there's no guarantee they'll be successful.

Alpha is also only one component of measuring how well an investment or fund performs. There are five key risk assessment ratios in modern portfolio theory:

• Alpha measures how well an investment performs relative to a benchmark.

• Beta measures volatility or risk. It can help tell you how much an investment moves relative to its benchmark.

• R-squared measures the correlation between the movement in an investment and its benchmark.

• Standard deviation also measures volatility, but is based on an investment's average returns rather than in relation to its benchmark.
• Sharpe ratio can help you understand an investment's historical risk-adjusted returns.

Investors and fund managers can use these to create investment portfolios that will attempt to generate the most returns relative to the risk.

How do you calculate alpha?

The most basic way to calculate alpha is to compare the return of an investment to its benchmark's return during the same period. You can start with this formula:

In this equation you have the following:

• Start price: The price of the investment at the start of the period. You can track alpha over different periods, such as one, three or five years.
• End price: The price of the investment at the end of the period you chose. It may be the current price.
• Distribution per share: The distributions (e.g., dividends or coupon payments) you've earned during the period you're tracking.

Let's say, for example, you want to find the alpha of an equity mutual fund compared to the S&P 500 during a one-year period.

If the fund started at $750, had $100 in distributions, and an end price of $900. Overall, it returned $250 / $750 = 0.33 (or 33%). If the S&P 500 had a 30% return during the same period, the alpha would be 3 (33 minus 30). But if the S&P 500 returned 35% during the period, the fund's alpha is -2.

Using alpha when making investment decisions

"Many retail investors don't care about alpha unless they're investing with a hedge fund or actively managed fund," says Noor. "It's starting to fall out of favor as people move toward index, passive investing." Which isn't necessarily a bad thing. Many actively managed funds have a negative alpha.

If you want to invest in actively managed funds or actively manage your own investments to try and beat the market, also beware of what the basic formula may be missing.

First, you need to be sure you're using an appropriate benchmark. For example, you wouldn't want to use a stock index as a benchmark for a fund that only invests in bonds.

With this in mind, you may want to take a skeptical look at funds self-reported statistics. "There are fund managers who said they could beat the market - beat their benchmarks," says Noor. "They set their own benchmarks, though."

Quick tip: Some screening tools will let you sort by funds' alphas. You may be able to sort the results from highest to lowest to find out how much (or little) investments outperformed their benchmarks in the past.

You also need to consider a fund's fees. If an actively managed mutual fund returns 1% more than its benchmark but charges 1.5% in fees, it could still have a negative alpha.

Additionally, alpha is a measure of historic returns. However, there's no guarantee that the investment or fund manager will continue to perform the same way in the future.

Alpha vs. beta

The simple alpha formula and the example above assumes that the fund and S&P 500 are equally risky. But this isn't always the case.

To accurately find a fund's alpha, you may first need to determine the fund's expected rate of return given its level of risk. Then, you can compare its actual return to its expected return and the benchmark's return. This is where beta comes in.

"Beta and alpha are terms used to describe the components of a portfolio's return," says Tim Bain, president and chief investment officer at Spark Asset Management. "Beta measures that portion of the return as it relates to the risk taken relative to the broad market, while alpha identifies that portion of the portfolio return that is a result of security selection."

Say the S&P 500 increases by 10% and a fund increases by 11%. If the fund is 10% riskier, it has a beta of 1.1. The higher rate of return was expected because of the beta, and, as a result, the alpha would be zero.

"If the portfolio took the same risk as the market, meaning a beta of 1, that extra return would have come from 'picking the right securities,' or alpha," says Bain. The alpha would be one.

Investors could use the capital asset pricing model (CAPM) to find the expected rate of return given an investment's beta. There's also a single, more complex financial formula for Jensen's alpha (also represented by the Greek letter α), which measures how well an investment performed relative to its expected return based on its risk.

The financial takeaway

Alpha can matter when you're actively managing your portfolio or considering investing in an actively managed fund. A higher alpha is always better, as it means you're getting a greater return on your investment. But you need to make sure a proper benchmark is being used, consider the fund's fees, and be certain that the return isn't due to increased risk.

There are also many investors who do well without seeking alpha. After all, alpha isn't necessarily something you need to worry about if you're investing in passive index funds.

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