Glossary
Alpha
The part of a portfolio's return not explained by its market exposure; positive alpha means it beat its risk-adjusted benchmark.
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Alpha is the portion of an investment's return that cannot be explained by its exposure to the overall market. If a fund earns more than you would expect given how much market risk it took, the surplus is positive alpha; if it earns less, alpha is negative. It is the number that tells you whether a manager added value or simply rode the market.
How it works
The most common version, Jensen's alpha, compares the actual return with the return predicted by the capital asset pricing model (CAPM), which depends on the risk-free rate, the market's return and the portfolio's beta.
Informally, people also use "alpha" for any return above a benchmark, ignoring beta. That looser usage is common in marketing material, so check which one a source means.
Caveats
Alpha estimates are noisy. One good year can come from luck, and a fund needs many years of data before its alpha is statistically meaningful. The figure also depends on choosing the right benchmark: a small-cap fund measured against the S&P 500 may show alpha that really reflects the small-cap factor. Long-run studies, such as S&P Dow Jones Indices' SPIVA reports, have found that most actively managed US stock funds trail their benchmarks after fees over periods of ten years or more.