**Introduction**

Before going any further, it is important to clarify the definition of alpha. According to investopedia.com, alpha is:

1. A measure of performance on a risk-adjusted basis. Alpha takes the volatility (price risk) of a mutual fund (or any managed portfolio) and compares its risk-adjusted performance to a benchmark index. The excess return of the fund relative to the return of the benchmark index is a fund's alpha.

2. The abnormal rate of return on a security or portfolio in excess of what would be predicted by an equilibrium model like the capital asset pricing model (CAPM).

This is certainly the standard definition of alpha as it is understood in most of the investment world. IFA, however, views alpha through the lens of multi-factor investing based on the three-factor asset pricing model that Fama and French introduced in 1993. The Fama/French three-factor model says the expected return of a broadly diversified stock portfolio in excess of a risk-free rate is a function of that portfolio's sensitivity or exposure to three common risk factors: (1) a market factor, as measured by the excess return of a broad equity market portfolio relative to a risk-free rate; (2) a size factor, as measured by the difference between the returns of a portfolio of small stocks and the returns of a portfolio of large stocks; and (3) a relative price factor, as measured by the difference between the returns of a portfolio of high book-to-market (or value) stocks and the returns of a portfolio of low book-to-market (or growth) stocks. The underlying premise of this model is that small cap and value stocks are riskier than large cap and growth stocks and thus carry higher expected returns. Given a time series of monthly returns of any diversified portfolio, the exposure to the three factors can be calculated via regression, and an expected future return may be estimated....

Institutional investors routinely pay investment consultants large sums of money to find managers who will deliver alpha. The problem is that very few (if any) investors receive alpha on a consistent basis. When one considers that the amount of alpha that is available for capture is zero before costs and negative after costs (see William Sharpe's paper, "The Arithmetic of Active Management"), it is easy to see why this is the case. Proponents of indexing often cite market efficiency as the reason for the futility of seeking alpha. One remarkable implication of Sharpe's thesis is that no assumption about market efficiency is necessary to establish the scarcity of alpha. The only two assumptions needed are that all market participants as a group receive the market return before costs and costs are positive. Besides, even if markets are not perfectly efficient, we know that they are efficient enough such that the total expenditure of resources spent on trying to beat the market is far higher than the total increase in returns resulting from these expenditures. In fact, returns received by investors are substantially lower because of these expenditures. Nevertheless, we still see billions of dollars spent on fund managers, investment consultants, rating services, etc. in the hope of capturing the ever-elusive alpha. Hope springs eternal..... Click Here to Read The Full Article (PDF)

## About Index Fund Advisors

Index Fund Advisors, Inc. (IFA) is a fee-only advisory and wealth management firm that provides risk-appropriate, returns-optimized, globally-diversified and tax-managed investment strategies with a fiduciary standard of care.

Founded in 1999, IFA is a Registered Investment Adviser with the U.S. Securities and Exchange Commission that provides investment advice to individuals, trusts, corporations, non-profits, and public and private institutions. Based in Irvine, California, IFA manages individual and institutional accounts, including IRA, 401(k), 403(b), profit sharing, pensions, endowments and all other investment accounts. IFA also facilitates IRA rollovers from 401(k)s and 403(b)s.

To find out more about the value of IFA click here. To determine your risk capacity, take the Risk Capacity Survey.