Opinion

Felix Salmon

Defining alpha

By Felix Salmon
May 28, 2009

One of the more challenging and interesting aspects of being a financial journalist is trying to define terms like convexity and covariance for a lay audience — it’s not easy. So I was particularly taken with Justin Fox’s one-sentence definition of alpha in his new book on the efficient markets hypothesis:

Alpha is a portfolio’s performance minus the performance of a hypothetical benchmark portfolio of equivalent risk.

Elegant, eh? It’s a shame, in a way, that it arrived just as the reputation of CAPM is hitting new lows and the race for alpha is looking increasingly laughable.

Comments
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try defining “duration”

Posted by bdbd | Report as abusive
 

In the same way that the prevalence and power of Ponzi Schemes is connected to the mellifluous sound of the name ‘Ponzi’, so Seeking Alpha drew its power from connotations with the concept of ‘Seeking Enlightenment’. Alpha is a powerful symbol as well, connoting both Science and Gematria. But, truly speaking, isn’t the importance of seeking in the very act of seeking? For example:

“Tzedek Tzedek Tirdof”

It doesn’t say anything about catching up. I think Proust means something similar when he says:

“car les vrais paradis sont les paradis qu’on a perdus.”

The opposite applies as well, as the Temptations put it so well in their classic song, which is especially relevant today, “Ball Of Confusion”:

“Run, run, run but you sure can’t hide”

One last point: In all these stories about how the future hasn’t turned out to be as cool as expected, with no flying cars, say; I am the only one who’s wondering about what happened to the Orgasmatron?

 

That is a good definition, indeed! Though hard to operationalize and easy to abuse. Alpha isn’t party to CAPM: alpha is the residual return in any factor model – it is what cannot be explained by common factor exposure.

(I don’t think CAPM is hitting new lows. Popular mis-sentiment waxes/wanes, but those who study/use it are pretty familiar with its striking absurdity in the real world. It has other uses … those who never had high expectation, count six unrealistic assumptions, can’t be much disappointed!)

And the “pursuit of alpha,” well i don’t know how that’s going, that’s a sort of ex ante view. Alpha is also mean to help us isolate (ex post) on skill/luck, so i think it will have a vital going forward role in risk – David Harper

 

time for my perennial complaint that the alpha measure doesn’t capture the returns to market timing at all well. If I buy and hold the S&P when it goes up 10%, then sell it just before it goes down 10%, then hold it when it goes up 1%, then what is the “equivalent risk portfolio”? Clearly, it’s the S&P, then cash, then the S&P. But this would suggest I’ve got alpha of zero in this example, whereas in fact I’ve made eleven per cent in a period when the market was flat.

Posted by dsquared | Report as abusive
 

@dsquared: agreed alpha doesn’t include “active benchmark timing” but skill still get’s credit for it.

 

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