Alpha is likely a mathematical artifact of hidden default risk rather than a measure of investment skill.
Fund managers use this excess return metric to prove they are geniuses who can beat the market. New research indicates that these gains might just be compensation for taking on risks that existing models fail to see. If the skill of the manager is actually an illusion, billions of dollars in performance fees are being paid for nothing. This finding challenges the fundamental way the global finance industry justifies its existence. Investors may be paying for magic that is really just an accounting error.
The Genesis of "Alpha": An Artefact of Methodological Ambiguity
SSRN · 6690358
Classical performance measurement in modern asset-pricing theory is anchored in benchmark-adjusted excess return—commonly termed alpha (α)—and in a family of reward-to-risk ratios built upon it. Once default risk is explicitly incorporated into the standard asset-pricing framework (Sharpe, 1964; Lintner, 1965; Mossin, 1966) and its extensions (Merton, 1973; Fama and French, 1993; Carhart, 1997; Fama and French, 2015; Idzorek and Ibbotson, 2021), however, a systematic bias in the classical metric