Alpha
Alpha is the part of a return that beats what the market or a benchmark delivered for the same risk. Positive alpha suggests skill or an edge; Jensen's alpha measures it against the return the CAPM would predict from the portfolio's beta.
Making 12% in a year sounds good — unless the market made 15%. Alpha is the measure that separates real outperformance from simply riding the market. Fund managers are paid, and judged, on it; traders chase it as proof of an edge. This entry explains simple alpha, risk-adjusted (Jensen's) alpha, and why it is much harder to find than it looks.
- Category
- Risk Management
- Reading time
- 4 min
- Also called
- Jensen's alpha, Excess return, Generating alpha
- Updated
Alpha in plain words
Alpha compares an investment's return with a suitable benchmark index such as the S&P 500; an alpha of +1 means it beat the benchmark by one percentage point over the period.1
Zero means it matched the market, and a negative alpha means it fell short.1
Alpha is usually read together with beta, the measure of how strongly an investment moves with the market.2
How to work out alpha, step by step
Choose a fair benchmark
One that matches the strategy's market and style. See Benchmark.
Measure both returns
Over the same period, including dividends. See Total Return.
Simple alpha
Portfolio return − benchmark return.
Adjust for risk
Estimate the expected return with CAPM using the portfolio's Beta. See Capital Asset Pricing Model.
Jensen's alpha
Actual return − expected CAPM return.
Check after costs
Fees and trading costs eat directly into alpha. See Trading Fees and Commissions.
Worked examples
Example 1 — Simple alpha
+4 alphaYour portfolio returns 14% in a year; the S&P 500 returns 10%.
| Alpha | 14% − 10% = +4 points |
A positive alpha means the portfolio beat its benchmark over the period.1
Example 2 — Jensen's alpha with leverage
+2.5 alphaA fund returns 16% with a beta of 1.5. The market returns 10% and the risk-free rate is 3%.
| CAPM expected return | 3% + 1.5 × (10% − 3%) = 13.5% |
| Jensen's alpha | 16% − 13.5% = +2.5 points |
CAPM sets the return a portfolio should earn for its beta; only the excess over that counts as risk-adjusted alpha.1
Example 3 — Alpha eaten by fees
Negative after costsAn active fund beats its index by 1.0 point before costs but charges 1.2% a year more than an index fund.
| Alpha before fees | +1.0 point |
| Extra fees | −1.2 points |
| Alpha after fees | −0.2 points |
Active funds have historically charged higher fees than passive ones, and higher fees can significantly lower returns.3
Alpha vs beta
| Aspect | Alpha | Beta |
|---|---|---|
| Measures | Return above the benchmark | Sensitivity to the market |
| Good value | Positive | Depends on the goal |
| Source | Skill or edge | Market exposure |
| Cost to obtain | High (active) | Low (index funds) |
How alpha is used
Judging fund managers
Did they earn their fees? See Active and Passive Management.
Testing a strategy
Does a backtest beat the market after costs? See Backtesting.
Pricing performance fees
Hedge funds charge for alpha. See Two and Twenty.
Comparing with other ratios
Alongside beta, standard deviation, R-squared and the Sharpe ratio.1 See Sharpe Ratio.
Advantages and disadvantages
Advantages
- Separates skill from simply riding the market.
- Easy to understand as a percentage.
- Jensen's version adjusts for market risk.
Disadvantages
- Depends heavily on choosing the right benchmark.
- Short periods can show alpha that is pure luck.
- Fees and taxes often wipe it out.
Going deeper
Read as far as you need. Each level builds on the one before it.
Why the benchmark matters
Beginner
A small-cap fund compared with the S&P 500 may show alpha simply because small caps had a good year. A fair benchmark holds similar kinds of assets. See Benchmark.
Skill depends on the manager
Intermediate
An actively managed fund's results depend heavily on the manager's skill, and active management often brings higher trading costs and taxes as well as higher fees.3 Those costs are the hurdle any alpha must clear.
Alpha or hidden beta?
Advanced
Some apparent alpha is really exposure to factors such as value, size or momentum that can be bought cheaply. Smart-beta funds package those exposures.2 See Factor Investing.
Common mistakes
Using the wrong benchmark
Comparing apples with oranges creates fake alpha.
Ignoring risk
Higher returns from more leverage are not alpha.
Trusting one good year
Luck looks like skill over short periods. See Sample Size and Statistical Significance.
Forgetting costs
Alpha before fees is not what you keep.
Check your understanding
Test yourself before moving on. Each answer comes with an explanation.
Key points to remember
- Alpha is return above a fair benchmark.
- Jensen's alpha adjusts for the portfolio's beta.
- Positive alpha suggests skill; negative means underperformance.
- Fees and costs often erase it.
- Judge it over long periods, not one year.
Frequently asked questions
Is a high alpha always good?
What is a good alpha?
Can individual traders have alpha?
Further learning
- Beta
The market side of the equation.
- Sharpe Ratio
Another risk-adjusted measure.
- Information Ratio and Tracking Error
Alpha relative to tracking error.
- Trading Edge
What alpha looks like for a trader.
Sources
This article is written in our own words. The sources below support the specific facts, rules and figures marked with a number in the text. Links open the original publisher’s page.
- Corporate Finance Institute. Alpha (opens in a new tab) Checked .
- Fidelity. Alpha, Beta, and Smart Beta (opens in a new tab) Checked .
- Investor.gov (SEC). Active Fund or Actively Managed Fund (glossary) (opens in a new tab) Checked .
Read more elsewhere
- Trading Metrics (our sister site): Alpha (opens in a new tab)
Educational content, not financial advice. Examples use hypothetical prices and simplified costs; actual fees, margin rules and regulations vary by broker, market and country. Trading Metrics is our sister site, under the same ownership; we are not affiliated with any other publisher linked above. Last reviewed . Report an error or request a source credit.