FINANCIAL TOOL
Alpha
When considering the use of an actively-managed portfolio, like a mutual fund or ETF, the alpha becomes an important consideration.
Alpha reveals whether a strategy outperformed or underperformed its passive benchmark, after adjusting for any differences in risk.
That is, for a given level of risk, did the fund managers’ decisions add or detract from the value of simply holding a passive benchmark tracker.
It’s important to note that, after fees, less than 10% of active portfolios have actually outperformed passive funds that track a benchmark over a ten-year period.
So consistent positive alpha is difficult to find.
In Morningstar and Yahoo Finance, you can view alpha as compared with the category. Sometimes the category itself is negative as well.
In the case that an entire category shows negative alpha (say, for example, large-cap value stocks), then if the ETF shows a better alpha than the category (even if it’s negative), that means the manager’s decisions added value.
You can typically view alpha over 3-, 5- and 10-year periods. The longer periods should hold a greater weight in one’s decision-making whether to use a fund or not.
In other words, negative alpha may still be a fine investment, so long as there is long-term consistency of the fund’s alpha outperforming the category or index.
Finally, alpha is only meaningful when comparing apples to apples. In other words, it wouldn’t make sense to analyze the alpha of a value stock fund in comparison with the S&P 500 (blend of growth and value stock). That wouldn’t tell you enough about the managers’ decision-making skills; it would mainly tell you how value stock as a stock style performed against the broader market.
So just make sure, when using alpha, that you are comparing the strategy with a benchmark of similar assets. Naturally, Morningstar and Yahoo Finance make this easy in their reporting.