Alpha

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Alpha /ˈalfə/ (n.)
Are you sure you’re not looking for our page on vega? [1]
Alpha, α, is one of the Greeks —the first of the Greeks — an expression beloved of unimaginative derivative salespeople and second-rate hedge fund managers and hence was much abused in the run up to the global financial crisis of 2008. Like many financial buzzwords, it is derived from portfolio management theory and does mean something though, through long misuse, that original meaning has largely fallen out of use. Technically, “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 value that manager adds that you would miss out on if you just invested in the market average.

But when you’re a salesperson, it’s easier than that. Alpha is just means “really cool”, which is why it’s so popular in new product acronyms: you know, Tactically Enhanced Alpha Receipts, or TEARs, which you can be assured you’ll eventually be in if you fall for a ruse as poor as that. Also, it’s a vowel, and you need 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.

Quite possibly both.

Beware of Greeks bearing leverage, therefore.

See also

References

  1. No offence, fellas. :-)