The development of the alpha coefficient dates back to 1968, with Michael Jensen as its author. The economist was concerned with one question: is it possible to assess the effectiveness of a fund manager based on historical returns and their ability to consistently outperform the market?
The approach involved comparing fund returns with a benchmark. To derive the formula, Jensen conducted extensive research, synthesizing information from 115 mutual funds. Subsequently, these returns were compared with the return of the S&P index over the same period. In total, the economist examined 10 timeframes, specifically from 1955 to 1964.
In general, Jensen's research showed that many fund managers underperformed the market, although some were able to outperform it occasionally.
The alpha coefficient is a metric that allows for the assessment of the skill level in managing the assets entrusted to the management company.
As for the formula for calculating alpha, there is more than one. However, they are all simply extensions of the primary formula derived by Jensen, which is expressed as follows: =Rp - *Rm.
Rp – represents the average return over a specific period;
– beta;
Rm – denotes the average return of the benchmark.
If all the aforementioned data is available, calculating alpha is straightforward. There should be no issues in finding the necessary parameters, as many funds today operate transparently, and the required information can be readily found online. Based on the available data, one can evaluate the performance quality of a specific company.
The alpha coefficient can be equal to zero, greater than zero, or less than zero, with all values indicating different scenarios.
If alpha is equal to zero, it implies that the management company is not attempting to outperform the market. Investing in such a fund would be tantamount to a regular purchase of securities that make up the fund's portfolio.
When alpha is less than zero, it can be confidently asserted that the company's performance is inefficient since the fund’s return is lower than the average market return. In situations with a negative alpha coefficient, it is advisable to avoid collaboration with such a fund.
An alpha value greater than zero indicates effective company performance, meaning the firm's actions result in asset returns exceeding the average market return. However, if alpha has a significantly high value, risks automatically increase. Nevertheless, it is possible to achieve an optimal balance between risk and return, where alpha should be high, and beta low, yet still positive.
Today, the alpha coefficient is essential for evaluating the effectiveness of actions taken by companies managing investment funds. The alpha coefficient enables the assessment of the average return of a portfolio. Of course, there are numerous other methods, but calculating the alpha coefficient provides the most accurate answer. From a mathematical perspective, it can be confidently stated that it allows for a comparison of the specific fund's returns with the returns of a benchmark portfolio, which may be based on a reputable index.
