getcracked
Blog / Technical

What is Alpha? (Excess Returns)

Technical

"We sell Beta. We hunt Alpha." - Every Portfolio Manager ever.

The Formula

$$ R_p = \alpha + \beta (R_m - R_f) + R_f $$
  • $R_p$: Portfolio Return
  • $R_m$: Market Return (S&P 500)
  • $R_f$: Risk-Free Rate (Treasuries)
  • $\beta$: Sensitivity to the market (Risk)
  • $\alpha$: The Skill (Excess Return)

What is Beta?

Beta is "cheap". You can buy an S&P 500 ETF (SPY) for 0.03% fees. If the market goes up 10% and you go up 10%, you have a Beta of 1. If the market goes up 10% and you go up 20% (because you used leverage), you have a Beta of 2.
You don't pay hedge fund fees for Beta.

What is Alpha?

Alpha is the return that cannot be explained by the market factor. It is the pure "skill" of the manager.
If the market is flat (0% return), and you make 5%, that is pure Alpha.
If the market crashes -20%, and you are flat (0%), that is +20% Alpha!

Where does Alpha come from?

  1. Information Asymmetry: Knowing something others don't (illegal if insider info, legal if better data analysis).
  2. Speed: Being faster than others to react to news (HFT).
  3. Structural Edge: Taking risks others can't (providing liquidity in a crash).