Summer is beginning to wind down and kids will be returning to school over the next several weeks. It’s probably a good time for those of us no longer in school to review the alphabet. However, we will do so in the context of investing. We will start at the beginning with “A” or “Alpha” which some of you may recognize as the first letter of the Greek alphabet.

When investment managers use the word “alpha” they are referring to the portion of investment performance that is generated by the manager. Now you might think, “Isn’t the investment manager responsible for all of an investment’s performance?” Actually, investment performance can be broken into two components. The base component is the return of the market. The additional component is that added by an investment manager, and is referred to as “alpha.”

The market return is the return an investor would earn by owning every available investment (US stocks, for example) in direct proportion to their size relative to the market. This “market” return is available simply by investing in an index fund. For example, the SPDR Standard & Poor’s 500 exchange-traded fund (ticker symbol “SPY”) tracks the US stock market (or, more accurately, the S&P 500 index). SPY was the first exchange-traded fund and it is also the largest. If we own “SPY,” we will earn a return equal to that of the largest US companies. SSGA, the manager of the SPY exchange-traded fund, charges its investors 0.0945% (the gross expense ratio) to manage this fund.

Investment managers generate “alpha” by actively managing their portfolios, in an effort to earn returns that are greater than the market’s return. For example, the Fidelity Large Cap Stock Fund (ticker symbol “FLCSX”) has an investment objective to “seek long-term growth of capital.” If we own “FLCSX,” our returns will be determined by the manager’s ability to generate “alpha.” Fidelity charges 0.67% to own this fund.

To further illustrate the concept, let’s assume the US stock market provided a return of 10% over the past 12 months. We could have generated that return by investing in “SPY”, or any similar low-cost index passive fund that tracks the US stock market. If an actively-managed fund returns 12%, we can say that the manager has generated “alpha” of 2%. If another similarly managed fund returns 8%, the manager has generated “alpha” of -2%, or “negative alpha”.

Investors who subscribe to the theory that it is possible for investment managers to generate “excess” return are willing to pay for active investment management. Those who believe managers cannot consistently add “alpha” over long periods of time gravitate toward low-cost, passive investment options.

OK. Class is adjourned. We will come back to the alphabet in a future post.

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