What Is Alpha?
The alpha definition in finance is the excess return on investment (ROI) above a benchmark from its asset category. It’s the subtraction of the realized return and the expected return, and it’s a result of active investing strategies. By contrast, beta is the passive expected returns linked to the inherent crypto market volatility.
“Alpha is a measure of the performance of an investment as compared to a suitable benchmark index, such as the S&P 500.”
Dr. Ribdi Alsaedi
“Alpha” also refers to any insider information or strategy that could give traders an edge in the market. It’s both the name of excess ROI as well as the “secret” that makes it possible.
When comparing investment funds, any option with alpha above 0 can potentially outperform the market in the future. For example, a fund that yields 8% when the benchmark does 5% has an alpha of 3%. If the benchmark returns -10% and the fund returns -7%, the 3% alpha is still positive and worthwhile.
Origin of Alpha
The alpha meaning in finance originated after the popularization of weighted index funds like the S&P 500 and Vanguard 500. Since these represented most of the market’s average performance, investors started looking for ways to outperform these benchmarks.
Since this was the case with more volatile assets, investors eventually developed a way to calculate expected returns relative to risk: the Capital Asset Pricing Model (CAPM) by William F. Sharpe, John Lintner, and Jan Mossin.
From this model, the economist Michael Jensen coined the term and formulated the “Jensen’s Alpha:”
What Are Examples of Alpha?
Both the simple and Jensen’s alpha are still used today to compare investments. The simplified version is as follows:
Alpha = Actual return – Benchmark Return
If a crypto portfolio returns 10% and the S&P 500 returns 4%, the simple alpha is 6%.
Of course, cryptocurrencies are a lot more volatile. For every 1% in the S&P 500, Bitcoin might go up or down by 3%. This would be called a beta of 3 (similar to leverage trading ratios).
The Jensen’s alpha formula adjusts for volatility risk by using the CAPM formula:
As another example, the alpha formula could start with these conditions:
- A crypto fund returns 20%
- The expected return is 10% (based on price history)
- The fund beta (compared to the S&P 500) is 1.5
- The benchmark returns 15%
- The risk-free rate is 2% (hypothetical value of investing in Treasury bonds and such)
For simplicity, assume a CAPM return of 14%.
The Jensen alpha is 20% (the fund’s return) minus 14% (CAPM), which is 6%. The simple alpha meaning is 20% minus 15% (benchmark return), which is 5%.
In this case, the fund outperformed both the benchmark (15%) and the expected risk-adjusted return (14%).
Integrating Alpha into Investment Strategies
Crypto traders have various ways to generate alpha and outperform Bitcoin on certain trends:
- Yield farming strategies involve researching different DeFi platforms and token pairs to maximize interest rewards. For example, the Yearn Finance aggregator reached Annual Percentage Yields over 1,000% at launch.
- Exchange arbitrage generates profits by trading the same asset at different exchange prices.
- Providing exchange liquidity generates fee revenue and “liquidity pool tokens” that add up after retrieving the initial amount.
Investors can also generate “informational” alpha by researching and discovering early-stage projects. This occasionally leads to free tokens (airdrops) and higher rewards at first.
Experienced traders can also get an edge by joining emerging blockchains where markets aren’t as efficient yet (e.g. Immutable X, Solana, Pulsechain…).
Conclusion
The alpha definition and goal is to outperform the expected market returns with as little risk as possible (beta). This involves complex active investing and experimentation with unique trading strategies. Monitoring for future crypto asset launches, discovering new tools, and other events can help traders find alpha.
Alsaedi, R. (2022, January). Alpha and Beta. Globalscientificjournal.com. http://www.globalscientificjournal.com/researchpaper/Alpha_and_Beta.pdf
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