Alpha has become one of the hottest investment concepts of the modern era, despite the fact it is often misunderstood by investors and sometimes misused by the investment industry. For example, you may hear investment managers (especially hedge funds) talk about an alpha-generating fund. You also may see examples of funds that point to their benchmark-beating performance as evidence of the alpha they are creating. Fortunately, this concept is simpler than it sounds and, when implemented in a well-diversified IRA portfolio, can have tremendous benefits for investors who take the time to learn how to use it.

What’s Alpha?

Alpha is a risk-adjusted measure of performance. It takes the volatility of a mutual fund 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. (For background reading, see The Uses And Limits Of Volatility .)

If the definition of alpha is a little confusing, it may be because for the purposes of measuring investment performance, alpha can only be evaluated in combination with another Greek letter, beta. For any given investment or investment portfolio, beta measures historic volatility compared to the market as a whole. The higher the volatility/risk, the higher the beta. (To read more, see Beta: Know The Risk and Bettering Your Portfolio With Alpha And Beta .)

For example, the market as a whole (often measured by the Standard & Poor’s 500 Index ) has a beta of 1. So, a mutual fund with a beta of 0.8 can be expected to demonstrate 80% of the market’s overall volatility. Alpha is effectively the component of risk-adjusted return that is not explained by beta, and a positive alpha indicates successful risk-adjusted performance. Once you understand these basics, three key points about Alpha should become clear:

1. Alpha can’t be projected or promised, and it isn’t baked-in to any given investment or strategy. It can only be measured historically, by looking back at risk and performance together. The historic time period chosen for the measurement is important and should be known.
2. When portfolios have risk profiles that are equal to or above the market’s average beta (1), it is difficult to generate alpha consistently over time because markets are competitive and somewhat efficient. A manager who produces a beta above 1 must consistently beat the market average just to produce an alpha of zero, indicating that no risk-adjusted value has been added or subtracted. (For more insight, check out Does Your Investment Manager Measure Up? )
3. A more effective way to generate consistent alpha is by aiming for consistent performance in a diversified low-beta portfolio. To build low-beta portfolios, investment managers combine asset classes that have low correlations with each other. This strategy can work because the investment correlations of asset classes are more persistent and predictable than investment returns.

Do-It-Yourself Alpha in Your IRA

The modern investment world at times makes alpha seem out of the reach of investors with modest assets or limited risk appetites. This aura has been perpetuated by hedge funds aimed at wealthy investors and the Greek letters inserted in investment marketing literature. However, if you keep in mind that alpha can only be measured retroactively (historically) and can best be generated by low-volatility portfolios, you will understand how accessible alpha-seeking strategies can be. Let’s take a look at how to increase the alpha of an IRA of virtually any size.

Hypothetically, let’s begin with two assumptions, neither of which may always be true but which together form a baseline for strategy building:

1. Look at historical data to identify pairs of assets (or asset classes) with consistently low correlations to each other. While correlations between assets do change over time, they tend to show some persistence.
2. Look at historical data to identify assets that have demonstrated consistent growth over time.

A Foundation Portfolio for Generating Alpha

One very simple and easy to implement portfolio has been an alpha-generating monster in recent years, and it consists of just two asset classes:

1. U.S. stocks
2. Oil futures

This pair of assets has had a low correlation over any historical period. For example, as of December 31, 2007, the correlation between the S&P 500 Index and oil futures was

-0.21 on a five-year look-back basis. A negative correlation indicates that stocks and oil futures are more likely to move in opposite directions during any given month than in the same direction.