What is Alpha?

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In the world of investments there are two main strategies in order to gain.

Passive Investing

The first one is called “passive investing” or also known as “index investing”. In this strategy a person invests a certain amount of money in an index fund which is not actively managed, whether by a human manager or a robot, AI (Artificial Intelligence), etc., but only follows the index which that fund is constituted on. For instance, an example of a tool for this passive investing strategy could be VWCE – Vanguard FTSE All-World Etf which seeks to track the performance of the FTSE All-World Index and is comprised of a representative sample of companies from that index. This by itself is a huge index, consisting of more than 3100 companies from more than 45 countries. This etf (VWCE) has no active management included in it (except in unusual circumstances). Not having an active investment manager for the index investment funds (current complete list of passive index funds from Morningstar) is a common feature for them so an investor could usually enjoy lower management fee than actively managed funds while taking part in the performance of the indexes.

Active Investing

The other strategy is called “active investing”. The main difference between the two is that in active investing there is someone actively managing the investment. By “actively managing” I mean a person or a robot, Ai, etc. is trying to actively select where to invest and when opposed to simply following the market movements as is the case with passive investing and index funds. Whether active investing really produces better results than the passive one is a question that remains open and to a great extent the answer accepted depends on the personal characteristics, including among others the risk tolerance and the psychological type of the ones asking it.

Where is Alpha in all this?

Alpha” belongs to the the world of active investment management. By simple words it means the extra return on an investment or capital investment managers are trying to achieve above the return they would have gotten if simply investing in an index fund or followed indices. In its narrow sense it’s a measure of how well those investment managers succeed in picking their investments and timing. The greater Alpha a manager is capable of achieve for a longer period of time, the more return to her/his investments they’ll get. Thus, managers consistently (and this consistency tested in various market conditions is important!) achieving higher alpha are paid more, hence the funds they manage may have higher management fees or charges. As long as the generated alpha is capable to cover the charges for the active management plus inflation and that figure stays above the return from a passive index fund, active management could deserve a try.

In a wider sense Alpha or more correctly – the pursuit of Alpha, could be viewed as every action on a set of capital or portfolio that seeks to increase its value in a greater way than if there was no action at all. Example of such actions could be short term options positions as in my case of the Alibaba stock or anything else that aims to take advantage of short term market movements, including but not limited to selling portion of a portfolio with the idea to buy that same portion later at a lower price.

Psychologically speaking the pursuit of Alpha is inherent to the human nature. Some of us are hunters and we like to think we can do better than the others. Some can, others not and it’s always mostly a matter of a long enough proper training and a mindset. A problem could arise when that pursuit becomes prevalently adrenaline driven. There is a saying in the field that no one is bigger than markets and in the modern world of algo trading, including AI systems, that saying seems to be more true than ever.

Respect and always take care of trading risks. 🙂

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