Alpha (α) is a fundamental yet poorly understood concept in finance. Simply put, it is the difference between the return of an investment and that of a risk-adjusted benchmark. In a more advanced definition, alpha is the residual in an asset pricing equation (see Appendix A). Alpha is what active managers strive to achieve and passive managers do not pursue.
Stock market bulls can find reassurance in the equity risk premium, which suggests stocks are valued fairly or slightly expensive.
It’s tempting these days for some investors to question the role of fixed income in portfolios. After all, real yields have plunged, potentially leading to less income today and smaller capital gains tomorrow.
Last March, we wrote a piece entitled “Equity Repricing Under a New Administration: A Tail Risk Scenario.” We posited that the proposed pro-growth tax and spending policies of the Trump administration, thrust onto an economy nearing full capacity, could lead to a general rise in the inflation rate and ultimately the real rate of interest.
With stocks hitting record highs, many investors want to mitigate the largest source of risk in their portfolios – equities. In recent decades, fixed income has served this purpose well. The asset class has generally delivered both positive returns and negative correlations with equities.
Ask an investor if most active bond funds outperform their passive counterparts and the response is likely to be "no."
