Alpha (Investment)

Alpha is a risk-adjusted measure of the "excess return" on an investment. It is commonly used to assess an active manager's performance, as it is the return in excess of a benchmark index or "risk-free" investment.

The alpha coefficient (αi) is a parameter in the capital asset pricing model. In an efficient market, the expected value of the alpha coefficient equals the return of the risk free asset: E(αi) = rf.

αi < rf: the manager has destroyed value
αi = rf: the manager has neither created nor destroyed value
αi > rf: the manager has created value

During the mid 20th century, it was observed that around 75 percent of stock investment managers did not make as much money picking investments, compared to simply invested in every stock in proportion to the market capitalization, or indexing.

Many academics felt that this was due to the stock market being "efficient" and that only luck made it possible for one manager to achieve better results than another.

A belief in efficient markets spawned the creation of index funds that seek to replicate the performance of investing in an entire market. The best examples are the S&P 500 and the Wilshire 5000, accounting for approximately over 80% and 99% of the total capitalization of the US market.

Investors now expect the investment manager to make more money than the passive strategy. The additional return above the expected return of the beta adjusted return of the market is called "Alpha".