Alpha

Lesson

Alpha is a measure of the performance of an investment relative to a benchmark index. It determines an investment's excess return compared to the overall market or a specific benchmark index. A positive alpha indicates that the investment has outperformed the benchmark, while a negative alpha indicates underperformance.

Practice Question #1

What does a positive alpha indicate about an investment's performance?

A) The investment has underperformed the benchmark index.

B) The investment has outperformed the benchmark index.

C) The investment has the same performance as the benchmark index.

D) The investment's performance cannot be compared to the benchmark index.

Select an option above to see an explanation here.

A) A negative alpha indicates underperformance. B) A positive alpha indicates outperformance. C) An alpha of zero indicates the same performance as the benchmark index. D) Alpha is designed to compare an investment's performance to a benchmark index.

Terms

Alpha:: A measure of the performance of an investment relative to a benchmark index.
Excess Return:: The return generated by an investment above the return of a benchmark index.
Benchmark Index:: A standard against which the performance of an investment can be measured.
Risk-Adjusted Performance:: The performance of an investment after accounting for the risk involved.
Active Management:: Selecting individual investments to outperform a benchmark index.
Passive Management:: Replicating the performance of a benchmark index by investing in all its components.

Practice Question #2

Which of the following is NOT a factor that can contribute to a high alpha?

A) Superior stock selection by an active portfolio manager.

B) Exposure to high levels of systematic risk.

C) A high risk-free rate.

D) Effective risk management strategies.

Select an option above to see an explanation here.

A) Superior stock selection can lead to outperformance and high alpha. B) Exposure to high levels of systematic risk can result in higher returns and high alpha. C) A high risk-free rate does not directly contribute to a high alpha, as alpha measures excess return above the benchmark index. D) Effective risk management strategies can help to minimize unsystematic risk and contribute to a high alpha.

Do Not Confuse With

Beta:: A measure of an investment's sensitivity to market movements.

Practice Question #3

Which of the following investment strategies is most likely to result in a portfolio with an alpha close to zero?

A) Active management with a focus on high-growth stocks.

B) Passive management using an index fund.

C) Active management with a focus on value stocks.

D) Passive management using a sector-specific ETF.

Select an option above to see an explanation here.

A) Active management focusing on high-growth stocks may result in a high or low alpha, depending on the strategy's success. B) Passive management using an index fund is designed to replicate the benchmark index's performance, resulting in an alpha close to zero. C) Active management focusing on value stocks may result in high or low alpha, depending on the strategy's success. D) Passive management using a sector-specific ETF may result in a high or low alpha, depending on the sector's performance relative to the benchmark index.

Historical Example

In the late 1990s, many technology stocks had high alpha values, indicating that they were outperforming the broader market. However, this outperformance was short-lived, as the technology bubble burst in 2000, leading to significant losses for investors who had chased high alpha stocks without considering the underlying risks.

Practice Question #4

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Example Series 65 Example Practice Question

Real-World Example

An investor holds a portfolio of stocks that have generated a return of 12% over the past year. The benchmark index for this portfolio has returned 10% during the same period. The portfolio's alpha is 2%, indicating that the investor's portfolio has outperformed the benchmark index by 2%.