Hedge Funds and Alpha

Quote from Rearden Metal:

He didn't say he made all that money by trading. I'd bet more millionaires than not, don't know what alpha means either.

Stated in the simplest possible terms, assuming the reader has next to zero market experience:

Alpha just means outperforming the most relevant index.
If a one year old hedge fund specializes in S&P 500 companies, and over the past year the S&P 500 has risen by 6% and the fund is up by 7%, the fund has <b>successfully</b> generated alpha.
If the S&P is up 50% and the hedge fund is up 49%, the fund has <b>failed</b> to generate alpha.
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Well, that's not entirely correct, it also depends on beta. The portfolio could have high beta and no alpha, or could have low beta and high alpha. You have to look at the risk of the portfolio, not just the excess returns above that of the market.

For example, if you ran a fund with, say, 0.8 beta, and the S&P had risen 6% but your fund only did 5%, you would have created alpha (because the portfolio was lower risk than the market).

P.S. I didn't bother to plug any hypothetical numbers into the above example, it is solely for the purpose of stating that alpha is possible even if you do not meet/exceed market returns.
 
Why does this sound like another Marketsurfer loaded question. In just a few pages, I bet this Preston Forbes will suddenly have a strong opinion and an axe to grind.
 
Quote from Chagi:

Well, that's not entirely correct, it also depends on beta. The portfolio could have high beta and no alpha, or could have low beta and high alpha. You have to look at the risk of the portfolio, not just the excess returns above that of the market.

For example, if you ran a fund with, say, 0.8 beta, and the S&P had risen 6% but your fund only did 5%, you would have created alpha (because the portfolio was lower risk than the market).

P.S. I didn't bother to plug any hypothetical numbers into the above example, it is solely for the purpose of stating that alpha is possible even if you do not meet/exceed market returns.
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You're right, my post was stupid. By keeping it <b>too</b> simple, I distorted the term.

Here's a much better definition:


Alpha
Measure of risk-adjusted performance. An alpha is usually generated by regressing the security or mutual fund's excess return on the S&P 500 excess return. The beta adjusts for the risk (the slope coefficient). The alpha is the intercept. Example: Suppose the mutual fund has a return of 25%, and the short-term interest rate is 5% (excess return is 20%). During the same time the market excess return is 9%. Suppose the beta of the mutual fund is 2.0 (twice as risky as the S&P 500). The expected excess return given the risk is 2 x 9%=18%. The actual excess return is 20%. Hence, the alpha is 2% or 200 basis points. Alpha is also known as the Jensen Index. Related: Risk-adjusted return.
 
There is also a difference between expected and realized return. When looking back at past performance one is looking at realized return, hence realized beta and alpha. Looking toward the future is the expected return. However, beta is fluctuating all the time, so regardless of what the beta of the portfolio was thought to be at the start of the year, the end of the year really tells the tale.
 
Fools and there money are soon parted. Mr. er Forbes, if you're a newbie that's too lazy to google, just admit it and post your question as such. If you actually have the money, DON"T invest it with anyone, you're clearly far too foolish to evaluate any hedge fund and are therefore extremely likely to be suckered into someone who will skim your life savings.
 
Quote from Rearden Metal:

You're right, my post was stupid. By keeping it <b>too</b> simple, I distorted the term.
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Well, I wouldn't call your post stupid, I just wanted to clarify regarding how risk fits into the equation.
 
Great responses here, I'm still going through the long answers and math. As to the posters who referr to myself as stupid for asking...look at the educated responses that came up here, I'm new to ET and was curious what kind of dialogue we have here...its far better than expected.
Realize that many many people in America have a few 100k extra to invest, whether it be from the sale of a house, or accumulated savings or income, its not some huge phenomenal number, and doesnt make them foolish for asking questions.
Here in San Diego, rental apartments, condos and houses we all bought by or near the beach less than 10 yrs ago, have gone up 20 fold.
Before this when I was in Seattle...colleagues at MSFT who have worked there the last 10 yrs, all have accumulated quite a portfolio of stock options, so just in my limited circle...exist many people who have money but are quite lost as what to do with it...we can't all believe everything our financial advisors or Morgan Stanley commercials tell us...I hope more people ask questions like this.
 
Preston, congratulations on sounding like a real person. I think it was the original wording of your post that suggested you might be just another ignorant rich guy pompously throwing big money around. Mention of specific $$$ was really not necessary. You must realize that many here may not be as fortunate as you, but they have market knowledge much greater than any broker and still have to work hard for their money.
 
I agree with Mr. Forbes. There are such things as stupid questions but that doesn't mean that one should be afraid of asking a question. There will always be questions to be asked and there will always be individuals who enjoy answering such questions.
 
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