Wednesday, February 24

Chasing Abnormal Returns or Alpha

Despite efficient markets which provide normal returns in the long run, active fund managers and capital market participants such as investors and traders often seek abnormal returns. Given the large pool of securities, market often 'misprices' some securities which provide opportunities to these fund managers to generate abnormal returns.

This abnormal return is known as Alpha Return.

The amount by which the investment is mispriced by the market becomes part of the total return expected by the manager over the holding period of investment. 

We call it ex-ante Alpha and is given by:

ex-Ante Alpha = Expected Return - Required Return
Note that we use various models to calculate the Required return such as Capital Asset Pricing Model (CAPM) ans represents a fair return expected on similar assets with similar risks.

Now Let's see how can we calculate the Expected Return.
For example, if an Analyst believes that a security which is currently priced at Rs 80 which should be actually priced at Rs 95 [i.e. it is undervalued by Rs 45]. This should be normalised within a year and the stock should be trading at its fair value in a year. Further, there should be a price appreciation of Rs 5 during this period. In this case, the Expected Return should be

Expected Return = [(95 - 80) + 5] / 80 = 25%
If the Required Rate of Return calculated using any of the methods (e.g. CAPM or APT) is 12%, the Alpha Return would be 25% - 12% = 13%

On a similar note, Managers calculate ex-Post Alpha whcih is given by:
Ex-Post Alpha = Historical Holding Period Return - Historical return on similar assets

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