Formula to Calculate Alpha of a Portfolio
Alpha is an index which is used for determining the highest possible return with respect to the least amount of the risk and according to the formula, alpha is calculated by subtracting the risk-free rate of the return from the market return and multiplying the resultant with the systematic risk of the portfolio represented by the beta and further subtracting the resultant along with the risk-free rate of the return from the expected Rate of the return on the portfolio.
The formula for calculation of alpha can be done first by calculating the expected rate of return of the portfolio based on the risk-free rate of returnRisk-free Rate Of ReturnA risk-free rate is the minimum rate of return expected on investment with zero risks by the investor. It is the government bonds of well-developed countries, either US treasury bonds or German government bonds. Although, it does not exist because every investment has a certain amount of risk., a beta of the portfolio, and market risk premiumMarket Risk PremiumThe market risk premium is the supplementary return on the portfolio because of the additional risk involved in the portfolio; essentially, the market risk premium is the premium return investors should have to make sure to invest in stock instead of risk-free securities., and then deducting the result from the actual rate of return of the portfolio.
Alpha of a Portfolio Calculation (Step by Step)
- Firstly, figure out the risk-free rate, which can be determined from the average annual return of government security, say Treasury bonds, over a substantial period.
- Next, figure out the market return, which can be done by tracking the average annual return of a benchmark index, say S&P500, over a substantial period. Consequently, the market risk premium is computed by deducting the risk-free rate of return from the market return. Market risk premium = Market return – Risk rate of return
- Next, the beta of a portfolio is determined by assessing the movement of the portfolio compared to the benchmark index.
- Now, based on the risk-free rate of return (step 1), a beta of the portfolio (step 3), and market risk premium (step 2), the expected rate of return of the portfolio is calculated as below. Expected rate of return of portfolio = Risk-free rate of return + β * (Market return – Risk-free rate of return)
- Next, the actual rate of return achieved by the portfolio is calculated based on its current value and the previous value.
- Finally, the formula for calculation of alpha of the portfolio is done by deducting the expected rate of return of the portfolio (step 4) from the actual rate of return of the portfolio (step 5) as above.
Let us take the example of a mutual fundMutual FundA mutual fund is a professionally managed investment product in which a pool of money from a group of investors is invested across assets such as equities, bonds, etc that has realized a return of 16% during the last year. The appropriate benchmark index for the fund has a book annual return of 11%. Further, the beta of the mutual fund vis-à-vis that benchmark index is 1.3while the risk-free rate of return is 4%. Do the calculation of the alpha of the mutual fund.
As per the question, the following is the data for the calculation of the alpha formula.
Expected Rate of Return
Expected rate of return = Risk-free rate of return + β * (Benchmark return – Risk-free rate of return)
- = 4% + 1.3 * (11% – 4%)
- = 13.1%
Therefore, Calculation of Alpha of the mutual fund will be as follows –
- Alpha of the mutual fund = Actual rate of return – Expected rate of return
- Alpha = 16% – 13.1%
Alpha Calculation of Mutual Funds
- Alpha = 2.9%
The alpha of the mutual fund is 2.9%.
Relevance and Uses of Alpha Formula
- The term alpha refers to the index used in many financial models, say the CAPM (capital asset pricing modelCapital Asset Pricing ModelThe Capital Asset Pricing Model (CAPM) defines the expected return from a portfolio of various securities with varying degrees of risk. It also considers the volatility of a particular security in relation to the market.), to assess the highest possible return from an investment with the least amount of risk. Alpha is also known as Jensen Index.
- It is essential to understand the concept of alpha formula because it is used to measure the risk-adjusted performance of a portfolio.
- It is also recognized as the excess return or the abnormal rate of return of a portfolio. The figure demonstrates how much worse or better a fund had performed concerning a benchmark. This variance is then credited to the judgments made by the fund manager. Active portfolio managersPortfolio ManagersA portfolio manager is a financial market expert who strategically designs investment portfolios. predominantly strive to generate alpha in a diversified portfolio (diversification is intended to eliminate unsystematic risk).
This has been a guide to Alpha Formula. Here we learn how to calculate the Alpha of a Portfolio using a practical example and downloadable excel templates. You may learn more about Financial Analysis from the following articles –