One of the first things that we learn in life is the alphabet. Through it, we form words and are able to communicate with one another using a common language. In investing, it would be useful if one of the first things that we learned about was the performance of our alpha bets. Why is alpha important? If an investor can persistently generate positive alpha, this may well be linked to investment skill. So, what is alpha and how good has the real estate industry been at generating it?
Alpha comes from the heyday of work on quantifying risk-adjusted performance, the 1960s. Sharpe, Treynor and Jensen all made contributions to the debate at the time but it is from Jensen’s work that alpha derives. For Jensen, the first question is what return should I have received given the sensitivity (beta) of my portfolio to market movements? Once that is calculated, you can compare the answer to the actual return; the remainder is alpha.
alpha = Rp – Rf – (beta x (Rm – Rf))
In words, this equation says that alpha is equal to the return on a portfolio (Rp), less the return on the risk free rate (Rf), less the sensitivity (beta) of the portfolio to the market’s return (Rm) less the return on the risk free rate (Rf).
Let’s consider a set of performance data for two portfolios where:
Rf = 1%
Rm = 6%
Rp1 (the return on portfolio 1) = 5%
Rp2 (the return on portfolio 2) = 7%
Beta1 (the sensitivity of portfolio 1) = 0.7
Beta2 (the sensitivity of portfolio 2) = 1.3
What are the values of alpha for portfolio 1 and portfolio 2?
Portfolio 1 has underperformed the market (5% – 6% = -1%) and has a performance delta (difference) of -1%. The world is not without people who would say the portfolio has an alpha of -1% but that is not correct since this underperformance is not risk-adjusted. The alpha of the portfolio is calculated as 5% – 1% – (0.7 x (6% – 1%)) = +0.5%. So, this portfolio has underperformed the market but delivered more return than you would expect given its sensitivity to market movements.