The mirage of Alpha

The mirage of Alpha

What is alpha - Generally, in common parlance and text book definition "alpha" is the excess return over the benchmark.

There are 2 sets of universe who are concerned with alpha. The fund managers and the investors.

From a fund manager perspective one can understand that he would like a barometer of measurement. Hence, the excess return over the benchmark is a matrix for his performance.

But does the same hold true for an investor? I humbly beg to differ here.

Let us look at 2 examples:

Scenario 1 - Smallcap funds in 2024 gave an average return of 39.4% and the benchmark gave a return of 49.1%. Is this performance bad for an investor and should he feel sad that the return is lower than the benchmark?

Scenario 2 - Smallcaps gave a return of -13% in 2018 and the benchmark gave -26%. Should the investor be happy with negative returns? Just because his loss is lower than the benchmark.

Investors would have a choice of investments and depending on the choice, the outcome will either be good or bad.

It is best that an investor sets a goal for himself, based on the risk he is taking to determine what should be his expected returns. Higher the risk; higher the return. Moreover, the expectations should not be unrealistic and there should also be an adequate time duration to allow that instrument to perform.

Ideally speaking a fair expectation for return from equity should be 2x post tax return generated by a fixed income instrument.

So for eg fixed deposits give a 7% pa return. Post tax will be between 4.9- 5.6% pa (based on tax slabs). 2x would be 10-11% pa post tax in equity instruments basically large cap. Add 2% pa for risk in midcap and say 4%pa for smallcap.

These are arbitrary figures and you can add your own risk premiums. Once that is set and if you get these returns then you should not worry what is happening around.

Set your own benchmark. There are no end to comparisons