Alpha is a measure of the difference between a portfolio’s actual returns and its expected performance, given its level of risk as measured by beta. A positive alpha figure indicates the portfolio has performed better than its beta would predict. In contrast, a negative alpha indicates the portfolio has underperformed, given the expectations established by beta.
Alpha can be used to directly measure the value added or subtracted by a portfolio manager. Alpha depends on two factors: 1) the assumption that market risk, as measured by beta, is the only risk measure necessary and 2) the strength of the linear relationship between the portfolio and the index, as it has been measured by r-squared. In addition, a negative alpha can sometimes result from the additional expenses that are present in a portfolio’s returns, as compared to the benchmark index.
Morningstar calculates this figure each month for different time periods.
For The Pros
In computing alpha, Morningstar deducts the risk-free return from the total return of both the portfolio and the benchmark index. Thus, the alpha figures shown by Morningstar may be lower than those published elsewhere. Morningstar believes that the calculation of alpha should represent the fact that every investor has choices about where to place his or her money.
Morningstar calculates a monthly measure of alpha and then annualizes it to put it in a more useful one-year context. The monthly measure of alpha is:
alphaM = – Beta()
= average monthly excess return of the portfolio
= average monthly excess return of the benchmark index
Beta = the portfolio’s beta
The annualized version of alpha is: