What is Alpha?

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You hear the word alpha a lot in the context of portfolio management. Everyone is trying to generate alpha. But what is it?

Put simply, it's the difference that a particular portfolio manager makes - it’s a measure of their secret sauce, their skill, their process, that allows them to ‘beat’ the market. If the relevant market return over a period of time is 5%, and a particular portfolio returns 8%, you can say that that portfolio has an alpha of 3% (8% - 5% = 3%).

The pursuit of alpha is the reason why people look beyond passive investing, relying on the proactive decisions made by a portfolio manager to try and generate excess returns.

However, as with all such strategies, chasing an excess return can come at the cost of additional risk, so the real skill lies in being able to generate alpha not just when markets are rising, but during downturns as well.