Alpha
Alpha, α, is one of the Greeks - the first of the Greeks - a buzzword beloved of unimaginative derivative salespeople and second-rate hedge fund managers and hence was much abused in the run up to the great financial crash of 2008. Like many financial buzzwords, it is derived from a technical term in portfolio management theory which does actually mean something, though through long misuse in the hands of such charlatans the original, literal meaning has fallen almost completely out of use.
In a technical sense, alpha is a measure of market outperformance: it gauges the variance of a portfolio’s performance over the market average, or "beta". An investment manager’s alpha, therefore, is the added value that manager brings you that you would miss out on if you just invested in the benchmark.
Hence why it’s so popular in enhanced acronyms, tending as they do to be a means of hawking a new products, which one likes to imply will be better than everything else out there. Alpha is thus a catch-all buzzword which more or less stands for “really cool”. And when have you ever known a salesman not to think his product is really cool? Also, it’s a vowel, and you need lots of vowels to make good acronyms.
The love-hate relationship between Alpha and Vega
All this talk of greeks brings to mind the critical distinction between alpha, beta and vega. Strictly speaking, the measure of alpha excludes the amplifying effects of leverage (borrowing to invest in the strategy, magnifying profits and losses of a dollar invested). Leverage increases the volatility of portfolio returns. But volatility is measured by vega, not alpha. While fund managers, particularly rubbish ones, are keen on conflating these two, they are, in fact, very different.
For one thing, it’s much easier to create vega: anyone and, indeed, everyone can: you simply introduce leverage. (Have a mortgage on your house? congratulations; you’ve generated vega).
Alpha, on the other hand, really is special, since QED only a certain portion of the market can generate it. Because it's an expression of variance from a mean, for every whizz-kid who generates positive alpha, someone’s generating an equivalent amount of negative alpha (i.e., returns than are worse than beta).
Why you should run for the hills when you see a product called leveraged alpha
"Alpha" was a far more credible label when hedge funds were a small segment of the market comprising the crème de la crème of the city’s trading talent - the Soroses and GLGs of the world, who really could outperform the rest of the market. If someone is incautious enough to claim they’re generating leveraged alpha, they’re either so stupid as to admit they're really just gearing the whoopsie out of your investment (if it goes wrong, guess who loses?), or they think you're so stupid you won't understand that.
And quite possibly both.
Beware of bearing leverage, therefore.
See also
- Greeks - the home of all things Greek on this site. It’s our own little Athens.
- Alpha
- Beta
- Delta
- Nu - a trick for young players — and those with a degree in Classics.
- Omega — the end of days, and the right time for backtesting
- Vega — not really a Greek at all, but a maudlin singer-songwriter
- Enhanced beta
- Leveraged alpha