What Is Alpha In Investing? - YouTube

Have you always been hearing fund managers  saying that, "Our funds are investing into alpha,  

our funds are generating alpha." So what is  exactly alpha generation? What is alpha?  

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Hi, my name is Louis. Your  financial educator.  

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You will find a lot of fund managers talking about  Alpha generation. What exactly do you understand  

by Alpha when it comes to fund management? What do  we mean by Alpha from a fund managers perspective?  

Let us start off with a fundamental question  on why we invest our money in mutual funds.  

The idea is that the fund manager should be able  to use his fund management skills, his team of  

traders and analysts to identify quality stocks at  attractive prices. That is what generates returns  

more than the index over the long run. For  example, if the KLCI index generates 8%  

returns during the year and the fund manager also  gives you returns of 8%, then there is no point in  

investing in an equity fund. On the other hand,  if the fund manager can give you returns of 12%,  

then the fund manager has generated the alpha.  You invest in an equity fund to earn more than  

what an index fund gives you. Otherwise, you are  better off investing in a passive index fund and  

earning returns without any worries. Let us understand what is alpha in finance  

and how to interpret alpha in finance. Alpha,  in simple terms is the excess return that the  

fund manager earns compared to what he is expected  to earn. That is alpha in investment management!  

For example, if the fund manager is  expected to provide a return of 10%  

yet he actually makes the fund perform 14%,  then he has generated excess return to the fund.  

He is a good fund manager and the fund is worth  investing into it. That brings us to the next  

logical question; how do we decide what is the  return that the fund manager is expected to earn.  

For that let us get back to a little bit  about key concepts of Beta and Alpha.  

What do we understand by Beta? Beta is a  measure of the systematic risk of a stock  

or a portfolio. When we talk of systematic risk  we refer to risks that uniformly impact all stocks  

in the market. This systematic risk is important  because this risk impacts all stocks and hence  

cannot be diversified away. For example, if you  are holding Tata Steel and you expect the steel  

demand to slow down then that is a risk unique  to the steel industry. That is an unsystematic  

risk and you can diversify that risk by exiting  Tata Steel and investing in a non-steel stock.  

That means, if anything happens to Tata Steel,  then you can pick another company to invest. But  

how do you handle a risk like Lehman Brothers that  impacts all stocks. That is systematic risk and  

cannot be diversified away. This systematic risk  is measured by Beta. What the beta here indicates  

is that if a portfolio with a beta of 1.2 is 20%  more risky than the market and a portfolio with a  

beta of 0.80 is 20% less risky than the market.  So if you have a higher beta then the expected  

returns on your portfolio will be higher and  if you have a lower beta then the expected  

returns on your portfolio will be lower. As we saw earlier, alpha is the excess returns  

that the fund earns over and above  what the fund is expected to earn.  

How is Alpha useful to mutual fund investors? Alpha clearly explains how much the fund is  

actually generating more than what it is actually  expected to generate. For example there may be 2  

funds which may have given returns of 22% and 29%  in the last 1 year. Your obvious reaction will be  

to conclude that the fund that returned 29%  is better than the fund that generated 22%.  

But the fund that generated 29% may have done so  with a Beta of 1.5 while the fund that generated  

22% may have generated a Beta of 1.1. Alpha  allows you to calculate risk-adjusted returns  

and that enables you to compare funds across the  equity category on a comparable basis instead of  

trying to compare apples and oranges. How is Alpha meaningful to fund managers?  

The alpha holds a mirror to the fund  manager’s performance after factoring  

in risk. The bottom-line is that it is the job  of a fund manager to either generate the maximum  

level of return for a given level of risk or to  minimize the risk for a given level of returns.  

Secondly, alpha may not be too relevant in a time  span of 1 or 2 years. Mutual fund investments are  

meant for longer time frames like 5-10 years.  Over such periods if the alpha is still zero  

or negative then it raises serious questions  over the ability of the fund manager  

to beat the market in risk adjusted terms. From a mutual fund investor’s perspective,  

there are times when most of the fund managers  are generating zero or negative alpha. That is an  

indication to the investor that she may be better  off investing in a passive index fund.  

Do you have a better idea of why people always  talk about Alpha and Beta? Let me know in  

the comment below what you have learnt. Like  this video if you find it useful and remember  

to subscribe to my channel. Thanks for  watching, see you in the next video!