“Alpha”: a vexatious lexigraphic obfuscation*
May 17th, 2007 | Filed under: CAPM / Alpha TheoryIt is common that certain cultures have numerous words for ubiquitous things in their society. For example, the Inuit (Eskimo) have over 30 words for “snow”, the Chinese have a dozen words for “rice”, and the British have many words for “stream”. But in the world of investing, there seems to only be one word for what is ostensibly its raison d’etre: alpha.
Maybe I’m working too much. But the more I research alpha, the less I know how to define it. While Andrew Lo asks “Where does alpha come from?”, I’m now back at “What is alpha”? For example, what might look like alpha over one timeframe is actually “exotic beta” when you shift the window of analysis only a few months. What looks like alpha vs. one benchmark may, of course, be beta when compared to a different benchmark. There’s ”active weight“, “active component“, “active share“, “absolute returns”, “reliance on public information“, “manager value-added” - even ”accidental alpha“.
Compounding the confusion are a seemingly infinite variety of definitions of alpha on the Internet. When I get an email asking me to define the beautiful variable, I have resorted to replying with a list of over a dozen definitions pulled from various sources. That list contains some pretty accurate definitions:
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Thank you for acknowledging the confusion surrounding of definition of Alpha.
As a portfolio manager, I frequently think about what makes my clients happy †Alpha, Beta or other feted or feared letters of the Parthenon. Perhaps it would be useful to focus on the various investment return properties that make Investors happy in order to understand what ‘Alpha’ is from their perspective?
In my experience, the following the three factors consistently rank highest as Investor pleasers: 1) expectation of positive performance above their benchmark; 2) stability of the return distribution, especially in the tails; and 3) the diversifying properties or lack of correlation of the Manager’s returns versus other portfolio holdings.
Institutional investors seek out these qualities. Maybe investment managers ought to focus on delivering these tangibles, rather than questing for ‘ubiquitous Alpha’?