Finding Alphas, 2nd Edition

1Introduction to Alpha Design

By Igor Tulchinsky

What is an alpha? Throughout this book, you'll read different descriptions or definitions of an alpha. Alpha, of course, is the first letter of the Greek alphabet – as in “the alpha and the omega,” the beginning and the end – and it lurks inside the word “alphabet.” Over the centuries, it has attached itself to a variety of scientific terms. The financial use of the word “alpha” goes back to 1968, when Michael Jensen, then a young PhD economics candidate at the University of Chicago, coined the phrase “Jensen's alpha” in a paper he published in The Journal of Finance. Jensen's alpha measured the risk-adjusted returns of a portfolio and determined whether it was performing better or worse than the expected market. Eventually, Jensen's alpha evolved into a measure of investment performance known simply as alpha, and it is most commonly used to describe returns that exceed the market or a benchmark index.

Since then, the term “alpha” has been widely adopted throughout the investing world, particularly by hedge funds, to refer to the unique “edge” that they claim can generate returns that beat the market. At WorldQuant, however, we use the term a little differently. We design and develop “alphas” – individual trading signals that seek to add value to a portfolio.

Fundamentally, an alpha is an idea about how the market works. There are an infinite number of ideas or hypotheses or rules that can be extrapolated, and the number of possibilities ...