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Investment alpha represents the degree to which an investment manager or fund can outperform a market benchmark or expected return.
The related concept of beta measures the risk in a portfolio relative to a broad market index. Since returns are expected to vary with risk, alpha is meant to describe a manager’s ability to achieve “excess returns” beyond what is typically expected for the risk involved.
Alpha can be measured against a benchmark of actual performance or theoretical performance. When measuring against actual performance, the benchmark should represent an investment portfolio that holds assets with similar risk characteristics. When measuring against theoretical performance, the benchmark is adjusted for risk by subtracting the risk-free interest rate (see “Jensen’s Alpha” below.)
In public equity, alpha is generally measured by comparing the performance of an actively managed fund or portfolio to a passive portfolio representing the benchmark index that the fund most closely emulates. In that context, Alpha is used by many investors to choose between passive or actively managed investments.
With private equity, the concept of alpha is slightly more complex, since private equity funds are by nature actively managed and there is no passive index of private equity performance to compare them to.
As in public equity, Alpha in a private equity fund represents the manager or general partner’s ability to generate a higher-than-expected return on invested capital. In the absence of a passive benchmark for private equity assets, however, private equity alpha is primarily determined using two methodologies:
Since investors in private equity often assume additional risks over public equity investments, alpha is about selecting the right fund manager – one who has the skills to manage those risks and deliver the rewards commensurate with the higher level of risk assumed.
An in-depth analysis by Bain & Company1 in 2014 evaluated the MOICs of nearly 2,700 deals from 1995 through 2006 vintages. The study concluded that three components of alpha explain the variance in the returns generated by GPs:
The Bain data affirms the validity of alpha in private equity funds by specifically identifying the traits of managers who are able to provide it. It can be seen from these traits that private equity alpha represents a different skill set than public equity alpha.
Jensen's alpha is a calculation of alpha that compares the performance of a fund or manager to a theoretical risk-adjusted benchmark rather than an actual one. The theoretical return used for Jensen’s alpha is the one that would be predicted by the capital asset pricing model (CAPM).
To calculate a CAPM risk-adjusted benchmark return, you need to know the beta of the fund or portfolio in question relative to a selected market index. Knowing that and the risk-free interest rate, the CAPM can provide an expected return for the fund against which actual performance can be compared.
Jensen’s alpha is infrequently used for private equity funds, however, due to the difficulty of determining a PE fund’s beta to a market index as well as the inherent uncertainties of the capital asset pricing model.
Both methodologies above have limitations, mostly stemming from the ability of the benchmark or index to accurately represent the nature of the fund for which alpha is being determined. As a relative rather than absolute measure, alpha is highly sensitive to the makeup and size of the comparison index or universe.
For a public market equivalent, the limitation is the relevance of the comparable index, which is challenging for unique investments such as buyout funds and venture funds, which do not really have direct public equity equivalents.
For peer benchmarks, the limitations involve the degree of similarity in strategy, size, sector and vintage versus the number of funds in the sample. A high degree of similarity, for example, among only a handful of other funds, may not produce a benchmark that provides an accurate picture of a manager’s relative performance to the true range of performance among other managers.
In its mathematical terms, alpha is the difference between the total return of a managed investment fund or portfolio and that of the benchmark or universe it is being measured against during the same time period. A basic formula for alpha can be written as:
Alpha = Total Return(fund) – Total Return(benchmark)
Alpha will be positive if the fund’s performance exceeds the benchmark for the same period of time and negative if the benchmark exceeds the fund’s returns.
Example:
The XYZ Fund had an annual return of 14.8%
A relevant benchmark had an annual return of 11.2%
Alpha = Total Return(fund) – Total Return(benchmark)
= 14.8% - 11.2%
Alpha = 3.6%
What is a good investment alpha?
An alpha that is positive represents a plus for investors. While the larger the alpha the better, an alpha that is positive means the investment manager more than compensated the investor for their fee.
What does a negative alpha mean?
A negative alpha means that the manager of the investment underperformed the benchmark or expectation and therefore cost more in fees than they added to the investment’s performance.
Alpha essentially measures the effectiveness of an investment manager. In doing so, it provides both investors and managers with valuable information on how the manager performed relative to other managers as well as whether they added or subtracted from the return potential of the underlying investment.
Important notice: This content is for informational purposes only. Moonfare does not provide investment advice. You should not construe any information or other material provided as legal, tax, investment, financial, or other advice. If you are unsure about anything, you should seek financial advice from an authorised advisor. Past performance is not a reliable guide to future returns. Don’t invest unless you’re prepared to lose all the money you invest. Private equity is a high-risk investment and you are unlikely to be protected if something goes wrong. Subject to eligibility. Please see https://www.moonfare.com/disclaimers.
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