How it works
Alpha falls out of the regression that produces beta: it is the y-intercept. Run a regression of strategy returns against market returns. The slope is beta. The intercept, after subtracting the risk-free rate, is alpha. Annualised alpha is what the strategy earned per year after accounting for market exposure. A 3 percent alpha means three percentage points of return came from skill, not from market beta.
Example
Fund A returned 18 percent over a year. Its beta to the S&P 500 was 1.2 during a year the S&P returned 12 percent. Expected return from beta alone: 12 × 1.2 = 14.4 percent. Alpha = 18 − 14.4 = 3.6 percent. Fund B returned the same 18 percent with beta 1.5; expected from beta = 18 percent. Alpha = 0. A and B looked the same on the headline, but A had real outperformance, B was just leveraged exposure to the market.
Why it matters
Alpha is what investors pay active managers for. Beta exposure is cheaply available via index funds, so a manager who only delivers beta after fees is destroying value. Real alpha is rare and difficult to identify: surviving 3 to 5 percent annual alpha after fees over a multi-year window is what separates legitimate skill from luck or hidden leverage. Always check fees against alpha, never against absolute return.
