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InvestingStocksBondsCryptoPersonal FinanceFundamental AnalysisTechnical AnalysisTradingBankingTaxes
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Alpha Generator

Alpha Generator
InvestingQuantitative Analysis

What Is an Alpha Generator?

An alpha generator is any security that, when added by an investor to an existing portfolio of assets, generates excess returns or returns higher than a pre-chosen benchmark without extra risk. Banks, hedge funds, and quantitative traders will now and again utilize algorithmic trading technology to assist with recognizing alpha generators that will permit them to outperform or beat the market over time.

An alpha generator can be any security, including government bonds, foreign stocks, or derivative products like stock options and futures. New alpha generators can likewise occur from the expansion of investments into another category.

How an Alpha Generator Works

Alpha generators can create substantially higher returns for investors. Alpha generators might be individual stocks, bonds, or derivative products. Frequently alpha generators occur from the expansion of an investor's passable universe. For example, adding international investments to broaden an investor's portfolio can result in higher returns from both fixed income and equity investments.

Since alpha can be a measure of the returns a portfolio produces in excess of the return estimated by the capital asset pricing model, on a risk-adjusted basis, theoretically an investor can measurably add to portfolio returns while expanding their investment universe to incorporate new types of alpha generators.

This should be in every way possible through modern portfolio theory, which considers targeted expansion of the investable universe and can result in an upward shift of the efficient frontier and capital market line when alpha generators are added. With new alpha generators affecting the capital market line, an investor's portfolio can expect to see higher returns through allocations that presently integrate new alpha-generating securities into the portfolio mix with negligible risk.

Alpha is one of five notable technical investment indicators that investors can use to assess the risk-return profile of an investment. The other indicators are beta, R-squared, standard deviation, and the Sharpe ratio.

International Investments as an Alpha Generator

International investments are one method for adding a targeted group of alpha generators to a portfolio. Emerging market investments, in particular, are one area that can broadly be considered alpha generators. Both emerging market debt and emerging market equity offer higher returns than average benchmarks worldwide with some extra risk.

An investor that expands their entire portfolio to incorporate emerging market investments can eventually shift their capital market line higher with the integration of emerging market debt in the more conservative portion of their allocations and emerging market equity in the higher risk portions of their portfolio.

Examples of Alpha Generators

Other areas of the market can substantially add alpha, specifically through more concentrated investments. An example of this is initial public offerings (IPOs), which can be a huge alpha generator. This group of the market offers high growth potential from companies that have laid out huge momentum. Investors can decide to invest in individual stocks, IPO funds, or index funds that track IPOs.

Other groups of the market frequently recognized as alpha generators incorporate FAANG stocks, BRIC countries, and Asia ex-Japan. A few investors may likewise track down critical alpha generation from the utilization of derivatives.

ESG Investing

Environmental, social, and governance (ESG) investing refers to an increasingly popular trend that empowers investors to put their money where their values are by investing in companies that adhere to specific criteria regarding environmental, governance, and social factors. ESG investing likewise helps steer investors from companies that face increased risk due to their environmental or social practices. ESG investing is frequently referred to as socially responsible investing or sustainable investing.

A 2021 study of financial professionals, fund selectors, and institutional investors shows that sentiment is shifting toward review ESG investing as an alpha generator. Over 60% of those institutions surveyed said there was alpha potential to be found in ESG, while 70% of fund selectors saw alpha potential in ESG. The survey revealed investor demand is energizing the growth of ESG investing, combined with growing social awareness, concerns about climate change, and a desire to be part of the green economy.

Highlights

  • Any security can be utilized as an alpha generator, whether it's a stock, bond, international equity, or derivative product.
  • An alpha generator is a type of security that when added to an existing portfolio can spark bigger returns than a pre-chosen benchmark with no extra risk.
  • International and emerging market stocks are a popular method for adding an alpha generator to a portfolio, as well as initial public offerings (IPOs) or funds that track IPOS.
  • In theory, an investor can grow their portfolio returns by expanding their targeted investment universe to incorporate alpha generators.