It’s a bit of a surprise that a term like alpha, described as excess return, has such wide appeal among financial advisors given its relatively technical origins.
Alpha is the intercept in a regression and its early use in the investment industry originates from research exploring whether actively managed mutual funds outperform on a risk-adjusted basis (the risk-adjustment part is the beta).
Investment alpha is portfolio-related actions, such as fund selection, asset class weights, tactical market-timing decisions, etc. that can result in investment outperformance.
Investment alpha is fundamental to the value proposition of most advisors (i.e., “I will build a portfolio that beats the benchmark”), which makes sense in an industry where compensation largely is tied to assets under management.
Clients want to feel like their advisor is adding value through professional management and doing better than the client could do on his or her (or their) own.
The thing about investment alpha, though, is that it’s pretty much a zero-sum game. For every winner out there, there has to be a loser, and that’s before considering fees.
This doesn’t stop many financial advisors from seeking investment alpha, and investment alpha from being the cornerstone of the value proposition.
Since alpha is often characterized as adding value, or at least the attempt to do so, the concept can be extended into other domains.
Tax alpha is one example and generally refers to strategies that increase the client’s after-tax rate of return or after-tax wealth. Another example is longevity alpha, which focuses on helping clients achieve sustainable lifetime income during retirement.
Because longevity alpha is focused on accomplishing a goal, it can include other types of alpha. Since improving portfolio returns would have an obvious positive impact on sustainability, longevity alpha would include concepts like investment alpha and tax alpha.
In other words, these alphas aren’t necessarily mutually exclusive.