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Alternative Market Briefing

Other Voices: Lies, damned lies and Alpha

Friday, May 15, 2015

amb
Andrew Beer
This paper was authored by Andrew Beer, founder of Beachhead Capital Management LLC, New York. You can download the full paper here.

Investors equate "alpha" to outperformance. A high alpha fund presumably delivers substantial excess returns relative to its benchmark. True alpha is short hand for manager skill. As we know, idiosyncratic returns can improve the risk-adjusted returns of a diversified portfolio, and hence investors will pay high fees for "alpha." Unfortunately, as a general rule, alpha is widely misunderstood and misused.

Statistically, alpha simply is the result of a linear regression between two return streams. The regression finds the straight line (ordinary least squares) that best fits the time series. Visually, beta is the slope of the line and alpha is where it crosses the vertical axis. The calculation was designed to uncover managers who outperform simply by taking on more risk. A manager who leverages to outperform the S&P in an up year will show a high beta but no alpha. Conversely, a manager who took less risk yet matched the S&P will have a beta of less than one and may show meaningful alpha. This analysis makes sense when you have two very similar investments. For instance, if a US-focused large capitalization mutual fund consistently earns 1% per annum more than the S&P with simila......................

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