Market forces play an important role in deciding how much you could earn on your investments. Rise or fall of interest rates, recession, market expectations and, in fact, any other macro phenomenon would affect your portfolio in one way or the other. But that doesn’t mean that every market race starts and ends with the daily rise or fall of market. Some investments might generate a return better than the overall market. The real challenge for market whiz kids lies in picking alpha-generating stocks.
Johnny: I have heard that many fund managers are pretty good in picking alpha-generating stocks. But perhaps I could appreciate their talent more if you could further elaborate what exactly alpha is.
Jinny: Market gurus divide the returns generated by any investment into two components: beta and alpha. On an earlier occasion, we had talked about beta. Just to recall, beta is the return generated by your investments due to the performance of the broader market. For instance, in respect of stocks, every rise or fall in the stock market would have some correlation with the rise or fall in the value of your stocks, which we measure in terms of beta. Beta is the return generated by your stocks simply because they are part of the market. High beta stocks, which have a beta of more than 1, rise or fall more than the broader market, whereas low beta stocks that have beta less than 1 rise or fall less. Such a return depends upon market risk or what we also call market volatility, which is reflected in the rise or fall of market prices. We can calculate the return generated by beta by using the capital asset pricing model, or Cap-m, about which we had talked last week.
But beyond the day-to-day fortune of beta, there lies alpha, which represents the return generated by a stock over and above what was contributed by market forces. Market volatility has no role in alpha and so we can say that it represents risk-adjusted return generated by an investment.
In other words, seeking alpha means getting extra return on your investments without taking extra market risk. That’s the real challenge for active fund management.
Illustration: Jayachandran / Mint
Johnny: What has seeking alpha to do with active fund management?
Jinny: Well, every active fund manager aspires to beat the broader market. But just beating the market in itself can’t tell you much about the performance of a fund manager. If the broader market, say, an index, generated a return of 10% over a period of time and your fund manager generated a return of, say, 15% during the same period, then at first glance your fund manger obviously looks like a winner. But you also need to consider how much additional risk the fund manager took for generating the additional return. We can’t consider the fund manager successful if he generated additional return by undertaking higher risk than the broader market. You need to look at additional returns on a risk-adjusted basis. A fund manager generating alpha adds value by generating a return higher than that of a broader market without taking extra risk. A fund manager generating positive alpha adds more value to the return generated by beta, hence the overall return is higher. But a fund manager generating negative alpha eats into the return generated by beta, hence the overall return is lower.
Johnny: Can you tell me why some fund managers end up with a positive alpha and some with a negative alpha?
Jinny: The first thing that you should keep in mind is that no stock can be permanently classified as an alpha generating stock. Some stocks at some point in time might generate a return higher than the return justified by their market risk. But the same stocks would not continue generating extra return for all time to come. Efficient markets quickly eliminate extra returns. So generating a positive alpha is a tough job.
The second thing is that finding alpha-generating stocks is a zero-sum game. A positive alpha generated by a fund manager comes at the cost of negative alpha generated by some other fund manager. You should keep in mind that everybody is competing to get a bigger share of the same pie but some would be getting a bigger piece only at the cost of someone getting a smaller portion. If some investors are generating higher return by assuming lower risk then there might be some investors who are generating lesser return by assuming higher risk. In the overall market, high return versus low risk and low return versus high risk cancel each other out. But why assume higher risk for lower return? You can call it wrong selection or error of judgement. But you should also keep in mind that the market works only because market participants differ in their judgement. Some win, some lose.
Johnny: Thanks, Jinny. I think alpha would continue to inspire awe in us. There are still many questions in my mind, but let’s keep them for some other ti me.
What: Alpha is the risk-free return generated over and above the return generated by a market index.
How: Alpha is generated by selecting investments that could give extra return without extra market risk.
Why: Getting alpha is tough because efficient markets quickly eliminate extra return.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them at firstname.lastname@example.org