Limitations of Alpha

As Alpha is a ratio that measures a fund manager's performance with a market benchmark, we intend only for the funds with high Alpha and ignore other funds.

But there are certain dos and don'ts to Alpha as well. Always remember Alpha and beta are of limited or no use if a fund doesn't have a high correlation or when compared to the incorrect benchmark.

That's why it's essential to check that a fund has a high R-squared with a benchmark before weighing its Alpha or beta.

If a fund has a low correlation with its index, its corresponding alpha statistic is not reliable, nor is the beta statistic from which the Alpha is derived.

Moreover, Alpha measures the past performance of the fund or portfolio; thereby, the expected similar returns from the portfolio are not entirely guaranteed. However, Alpha gives an idea about the fund manager's performance in steering the fund performance and stock-picking abilities.

Thus, as high Alpha doesn't provide complete evidence of a fund's performance, we should not rely on Alpha only as a primary factor in picking the funds. The change in other risk-to-reward ratios such as Sharpe and Treynor ratios, market outlook, and sector allocation of the funds also should be seen.

To read more on the working and calculation of Alpha. Please check our article on IMPORTANCE OF ALPHA AND HOW TO CALCULATE ALPHA OF AN INVESTMENT.

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