Formula to Calculate Alpha of a Portfolio

The alpha calculation formula can be used first by calculating the expected rate of return of the portfolio based on the risk-free rate of returnRisk-free Rate Of ReturnA risk-free rate is the minimum rate of return expected on investment with zero risks by the investor. It is the government bonds of well-developed countries, either US treasury bonds or German government bonds. Although, it does not exist because every investment has a certain amount of risk.read more, a beta of the portfolio, and market risk premiumMarket Risk PremiumThe market risk premium is the supplementary return on the portfolio because of the additional risk involved in the portfolio; essentially, the market risk premium is the premium return investors should have to make sure to invest in stock instead of risk-free securities.read more, then deducting the result from the actual rate of return of the portfolio.

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Alpha of a Portfolio Calculation (Step by Step)

Examples

  • Firstly, figure out the risk-free rate, which can be determined from the average annual return of government security, say Treasury bonds, over a substantial period. Next, figure out the market return, which can be done by tracking the average annual return of a benchmark index, say the S&P 500, over a substantial period. Consequently, the market risk premium is computed by deducting the risk-free rate of return from the market return. Market risk premium = Market return – Risk rate of return Next, the beta of a portfolio is determined by assessing the portfolio’s movement compared to the benchmark index. Now, based on the risk-free rate of return (step 1), a beta of the portfolio (step 3), and market risk premium (step 2), the expected rate of return of the portfolio is calculated as below. Expected rate of return of portfolio = Risk-free rate of return + β * (Market return – Risk-free rate of return) Next, the actual rate of return achieved by the portfolio is calculated based on its current value and the previous value. Finally, the formula for calculation of alpha of the portfolio is done by deducting the expected rate of return of the portfolio (step 4) from the actual rate of return of the portfolio (step 5) as above.

The following is the data for calculating the alpha formula per the question.

Expected Rate of Return

Expected rate of return = Risk-free rate of return + β * (Benchmark return – Risk-free rate of return)

  • = 4% + 1.3 * (11% – 4%)= 13.1%

Therefore, the Calculation of the Alpha of the mutual fund will be as follows –

  • Alpha of the mutual fund = Actual rate of return – An expected rate of returnAlpha = 16% – 13.1%

Alpha Calculation of Mutual Funds

  • Alpha = 2.9%

The alpha of the mutual fund is 2.9%.

Relevance and Uses of Alpha Formula

  • The term alpha refers to the index used in many financial models, such as the CAPM (capital asset pricing modelCapital Asset Pricing ModelThe Capital Asset Pricing Model (CAPM) defines the expected return from a portfolio of various securities with varying degrees of risk. It also considers the volatility of a particular security in relation to the market.read more), to assess the highest possible return from an investment with the least risk. Alpha is also known as Jensen Index.It is essential to understand the concept of the alpha formula because it is used to measure the risk-adjusted performance of a portfolio.It is also recognized as the excess return or the abnormal rate of return of a portfolio. The figure demonstrates how much worse or better a fund had performed concerning a benchmark. This variance is then credited to the judgments made by the fund manager. Active portfolio managersPortfolio ManagersA portfolio manager is a financial market expert who strategically designs investment portfolios.read more predominantly strive to generate alpha in a diversified portfolio (diversification is intended to eliminate unsystematic risk).

This has been a guide to Alpha Formula. Here we learn how to calculate the Alpha of a Portfolio using a practical example and downloadable excel templates. You may learn more about Financial Analysis from the following articles –

  • Formula of Tracking ErrorFormula Of Tracking ErrorTracking Error Formula is used in order to measure the divergence arising between the price behavior of portfolio and price behavior of the respective benchmark and according to the formula Tracking Error calculation is done by calculating the standard deviation of the difference in return of the portfolio and the benchmark over the period of time.read moreSecurity Market LineWhat is the Risk Premium Formula?Cost of Equity FormulaCost Of Equity FormulaCost of Equity (Ke) is what shareholders expect for investing their equity into the firm. Cost of equity = Risk free rate of return + Beta * (market rate of return - risk free rate of return). read more