In their fourth-quarter (Q4) 2018 outlook, K2 Advisors’ Research and Portfolio Construction teams take a deeper look at alpha, and why they feel it’s misunderstood. They believe offering these insights will help investors better understand the rationale for owning retail mutual funds that invest in hedge strategies.

Alpha Is Hard

For this quarter’s outlook we are taking a deeper look at alpha. For hedge funds, the importance of this measure cannot be overstated. The problem, from our perspective, is that often it is misunderstood. From a purely qualitative standpoint investors understand alpha as the value that an active portfolio manager adds to or subtracts from a fund’s return, depending upon his or her skill as an investment manager.

Fair enough. But when conversations turn to measuring this fleeting statistical phenomenon, things can get a bit more ambiguous.

Often alpha is talked about in the abstract. A precise quantitative measure is sometimes not specified or, if it is, the calculation may be flawed. Ad-hoc or loose definitions are also often used and never tested for validity.

To be clear, we are not casting aspersions. We understand the challenge. For all intents and purposes, alpha—in the purest mathematical sense—is hard. It is hard to quantify, hard to consistently measure, and even harder to capture. Sometimes asset management marketing materials describe “generating” alpha.

To be precise alpha cannot, in fact, be “generated.” It can only be captured—and it is in short supply. Over time and across markets it represents a zero-sum game. To obtain alpha means taking it away from someone else.

Mathematically speaking (and we are sorry for this), alpha represents the abnormal rate of return on a security or portfolio in excess of what would be predicted by an equilibrium model like the capital asset pricing model (CAPM). The CAPM says that the expected return for an investment is proportional to its exposure to systematic, or non-diversifiable, risk.