Alpha generation refers to the creation of a portfolio that gives a different return from what would be expected given the level of risk in the portfolio. Alpha is often used as a way to measure the performance of a portfolio manager, with positive alpha generation meaning that the manager created a portfolio that returned more than one would expect for its riskiness, and negative alpha generation meaning that the manager created a portfolio that returned less than one would expect for its riskiness. Essentially, alpha allows one to compare the returns of portfolio managers while taking into account the risk that was assumed in order to achieve the returns.

First used by Michael Jensen in the 1970s, and sometimes referred to as Jensen's alpha, the variable was based on a derivation of the Capital Asset Pricing Model (or CAPM). Under certain assumptions about the market, assets, and investors, CAPM posits that the expected return of a portfolio is equal to a base rate of return plus compensation for the risk of the portfolio. The base rate is the risk-free rate of return on an asset and, because the portfolio is assumed to be well-diversified, compensation for the risk comes entirely from the portfolio’s non-diversifiable, or market, risk. This is calculated as the product of the portfolio’s beta, or sensitivity to movements in the market, and the market premium, or expected return on the market minus the risk-free rate. Alpha is then the difference between the actual return and this expected return given by CAPM.

It is important to note that when calculating the alpha generation of a portfolio manager, one is implicitly assuming that CAPM is a valid asset pricing model. However, this particular model has been called into question in academic literature, with critics arguing that its assumptions do not hold in the real world, among other things. For this reason, alternative asset pricing models, such as Arbitrage Pricing Theory (or APT), have been put forth.

CAPM captures the risk of a portfolio based on its movement with the market. However, other risk factors have been shown to be important for explaining asset returns on a more empirical basis. Based on APT, the Fama-French three-factor model includes additional risk factors for size and book-to-market values. The concept of alpha generation can be extended to these models as well, as alpha simply remains the extent to which actual return exceeds or falls short of the predicted return.

In practice, it is hard to consistently achieve positive alpha generation, as to do so means to gain additional return without taking on additional risk in a market in which one is interacting with others who are trying to do the same thing. But due to the appeal of alpha, managers of hedge funds and mutual funds engage in, and will likely continue to engage in, the pursuit of alpha through a variety of alpha strategies.