Factor Exposure Analysis 111: What is Alpha?

Comparing different alpha calculation methodologies

March 2025. Reading Time: 10 Minutes. Author: Abhik Roy, CFA.

SUMMARY

  • Jensen’s alpha methodology is popular, but has several drawbacks
  • There is no perfect methodology, but some are more easy to understand than others
  • We prefer the residual return (beta-adjusted excess return) approach given its robustness and simplicity

INTRODUCTION

Since Michael Jensen formalized the concept of alpha in his 1968 paper, The Performance of Mutual Funds in the Period 1945-1964, it quickly became a key metric for fund managers to measure their ability to outperform the market, driving its widespread adoption.

However, Eugene F. Fama and Kenneth R. French later introduced their three-factor model, demonstrating that alpha often diminishes when portfolio returns are adjusted for three key factors: market, size, and value. Over time, additional factors have been identified, further explaining excess returns and reducing the magnitude of alpha (read Outperformance Ain’t Alpha).

But a lot of these models may seem too theoretical, which can then lead to investors questioning the practicality of the metric. In this research, we will compare different methods for calculating alpha.

ALPHA AS THE INTERCEPT

As per the initial paper by Michael Jensen, “alpha” was calculated based on Capital Asset Pricing Model (CAPM), taking the intercept of the regression as alpha, while beta became the measure of systematic risk. The frequency of the data used were annual. Below is an excerpt from the paper: