What does the term "alpha" measure in finance?

The term "alpha" in finance is primarily used to measure the active return on an investment relative to a benchmark index. It represents the value that a portfolio manager or an investment strategy adds to or subtracts from the performance of a benchmark index. A positive alpha indicates that the investment has outperformed the benchmark after adjusting for risk, while a negative alpha signifies underperformance.

Alpha is essential for investors and analysts as it provides insight into the effectiveness of the investment strategy. Understanding alpha allows investors to evaluate the skill of portfolio managers and make informed decisions based on performance that exceeds passive indexing strategies, particularly in active management contexts. This concept is especially relevant when assessing mutual funds or hedge funds, where active management aims to generate excess returns beyond the market or a specified index.