Alpha investing

One of the most common indicators we often hear from fund managers when they talk about investment performance is the term alpha.

It may sound highfalutin when you hear it for the first time, but when you get used to it, you will understand the alpha is simply a measure of how well a stock or a fund has outperformed the market over a period of time.

For example, if you invest in a stock that earns 15 percent while the market gains 10 percent, the excess return of the stock, called the alpha, is 5 percent.

If you are planning to buy mutual fund shares, you can use the alpha as a tool to evaluate and rank the funds before you decide to invest. The larger the alpha, the more promising the fund will perform in the future.

But the alpha can mean different things to different people.

Depending on how you define the standards in measuring the alpha, the excess returns of a stock can change significantly from one benchmark to another.

Let’s take the case of JG Summit (JGS). This stock has generated a total year-to-date gain of 17.6 percent. If we compare the returns of JGS against the PSE index’s gain of 6.8 percent this year, the stock can easily produce an alpha of 10.8 percent.

Now, JGS has a beta of 1.56, which indicates that the stock is 56 percent more volatile than the PSE index. This means that if the PSEi has advanced by 6.8 percent, the stock should have gained about 10.6 percent to cover the additional risk.

Since the actual return of the stock was 17.6 percent, the alpha of the stock will come out lower at 6.9 percent.

Perhaps, the most ideal benchmark is the minimum return based on opportunity cost, which is derived by taking the sum of the “risk-free” rate as represented by the 10-year bond yield and the risk premium.

This measure determines the amount of returns that you should expect in exchange for the risk you take in putting your money in stocks.

At an interest rate of 6.04 percent, the minimum return of JGS is 13.8 percent. Using this as a basis, the alpha of the stock will be much lower at 3.75 percent.

Be that as it may, a positive alpha is still an excess return. It means the return generated by the stock can more than compensate the risk of the investment.

Not all stocks can consistently produce a positive alpha. About half of the stocks in the PSE index currently have positive alpha over the market’s year-to-date return.

When the opportunity cost is used to measure the alpha, the number of stocks falls by 27 percent to only a third of the PSEi.

The alpha stocks, aside from JGS, include Alliance Global (+27.4 percent), Bloomberry (+24 percent), ICTSI (+20.5 percent), San Miguel (+12 percent), Universal Robina (+11 percent), Robinsons Land (+10 percent), Puregold (+6.5 percent), Security Bank (+4.6 percent) and First Gen (+2.2 percent).

Interestingly, during the 2017 bull market, the number of alpha stocks was about two-thirds of the PSE index with median returns of 26 percent.

Last year, when opportunity costs were higher due to the rise in interest rates, there were only four alpha stocks with median return of only 11 percent.

These stocks were First Gen (+9.1 percent), Jollibee (+4.1 percent), Meralco (+7.0 percent) and San Miguel (+23.8 percent).

This year, despite the recovery in the share prices, the median return of the present alpha stocks so far is only 12 percent.

If the stock market will continue to trend upward over the coming weeks, we should expect the number of alpha stocks to rise with larger returns.

The potential alpha stocks are those blue chips with relatively lower required returns based on prevailing opportunity costs.

These are Ayala Corp., Ayala Land, Globe Telecoms, Jollibee, LT Group, Megaworld, Metrobank, Metro Pacific Investments, Robinsons Retail, SM Investments and SM Prime Holdings.

While investing with alpha strategy can help identify stocks that outperform, bear in mind that these are historical indicators and past performance is not a guarantee of future results.