What it means
Alpha is a measure of value that a manager brings to a fund. It is calculated by comparing the performance of a fund against its benchmark, usually an index (for most UK equity funds, for example, this will be the FTSE All Share).
As Richard Hancock, analyst at Investment Maze financial advisers, puts it: "Alpha is an additional return above the market as a result of active management and stock selection."
Calculating Alpha is slightly more complicated, however the majority of investors are unlikely to ever have to work this out for themselves. Publicly available factsheets, such as those on FE Trustnet, will usually show a fund’s Alpha score.
Every January, FE Trustnet publishes its FE Alpha Managers list, which is the 110 managers who added the most Alpha to their fund over the preceding 12 months.
Why it is important
When markets are booming it is not regarded as difficult to make a return on investments, but when markets are flat or volatile, as they have been so far this year, the task becomes much harder.
This is where the value of Alpha becomes apparent, as managers with the trait will still tend to offer attractive returns either through stock-picking or timing their investments. Similarly, when markets are plummeting, as they were earlier this August, managers can add Alpha when their investments lose less than the rest of the market.
Useful for…
"How important Alpha is depends on what market and sector you are investing in," explained Hancock.
"In a bull market, Beta [a measure of how closely a fund’s performance follows its benchmark] is more important. The more active the investor, the more they need to know about Alpha."
Clive Collins of McCarthy Taylor Limited said: "Investors that are prepared to accept risk and are hoping for returns in excess of the risk they are taking on definitely need to understand what Alpha is."
Considerations
Owning a fund with a high measure of Alpha is not the be-all and end-all.
"Most clients are more interested in how much money they are getting rather than their returns in relation to the market," Collins continued. This is an important point, as a manager with a high measure of Alpha may be outperforming his benchmark, but if he operates in a market that is falling, he could be returning less to investors than a manager who has a negative Alpha but who is operating in a rising market.
It is also worth bearing in mind that just because a manager has added Alpha to his fund in the past, it doesn’t mean he will continue to outperform the market. Lothar Mentel, chief investment officer at Octopus, said: "It is important to find out if the Alpha they are seeing is sustainable, whether it has come from skill or luck, is it more broad-based or is it consistent."
Jan Luthman, manager of CF Walker Crips Equity Income, said: "The models that calculate risk focus on past performance. My problems with these are firstly that they don’t say why the volatility occurred, and secondly don’t say whether it is likely to occur in the future."
Example
L&G UK Alpha is a good example of a high-Alpha fund.
Performance of fund vs benchmark index since launch
Source: FE Analytics
It has an Alpha of 14.15 per cent, making it the fund with the sixth-highest score in the IMA universe. Since its launch in May 2005, the fund has returned 129.2 per cent, while its FTSE All Share benchmark has returned only 40.92 per cent.