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Friday, January 31, 2014

What is Alpha of Portfolio?

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Alpha represents the difference between the fund's actual return and the expected return, given the fund's beta. It is basically a measure of outperformance. A positive alpha implies that a fund has outperformed its benchmark index. An alpha of 2 would indicate that a fund has provided 2% higher returns than the market while an alpha of -2 would indicate that the fund has produced 2% lower returns than its market benchmark. A positive alpha is what one seeks. Here we talk about equity funds and alphas are most suitably used for these stock funds. Mathematically, alpha is measured as:

Alpha (?) = (Actual return of fund - risk free return) - beta of fund*(benchmark return - risk free return)

Working for a one year performance period:

Illustration:Actual return of fund: 30, Risk free return: 8%, Beta of fund: 1.1, Benchmark return: 20%

? = (0.30-0.08)- 1.1*(0.20-0.08) = 0.088 i.e. The fund has outperformed the benchmark index by 8.8%

Alpha represents the value added to a fund by superior stock picking skills of the fund manager.

 

 

 

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