Alpha is a measure of the “extra” return generated by managers over the general market which is often represented by an index.It is important to be conscious of the amount of risk a manager undertakes to achieve their returns, and true alpha is the risk-adjusted returns a manager acheives. One reliable measure of risk-adjusted return is the Sharpe Ratio.

“Alpha” is the holy grail of hedge fund managers. It’s the measure of the “extra” return they generate through their skills, over and above the expected return you would get in the general market, say through an index fund.

Q: OK, that sounds pretty simple. So if the S&P generates 6% in a year, but my hedge fund generates 8%, I have 2% Alpha…
A: Pretty much, but there’s a very important detail to consider, especially when you’re looking at making an investment and you’re being told that the manager has been generating Alpha. True Alpha, the kind that definitely worth paying for, takes account of the risks that the manager took to generate the return.

Q: So, true Alpha is the risk-adjusted extra return the manager earns?
A: Exactly. Extra risk should mean the potential of extra reward, so someone who’s running a riskier portfolio well ought to be out-performing general stock market indexes. You have to compare risk apples to risk apples to really understand whether someone is generating true alpha. And the fact is that it’s a very hard thing to do on a consistent basis.

Q. So how does an investor go about evaluating that?
A: Well, there are several statistical measures that people in the hedge fund world use to understand how much risk a manager has been running in his portfolio. We’ll review several of these in our buzzword segments. But to pick just one, let’s go with something called the Sharpe Ratio, which essentially is a measure of return for unit of risk. A Sharpe Ratio of 1 or better is considered good; two is very good; and three is outstanding. A negative Sharpe Ratio is bad. So the next time you run into a hedge fund manager at a cocktail party and he’s bragging about his returns, just ask him what his Sharpe Ratio is… then he’ll know that he’s talking to a pro.