Chartered Alternative Investment Analyst Association (CAIA) Practice Exam

Which of the following best describes an advantage of Alpha in investment analysis?

1. Allows investors to avoid systematic risk

2. Adjusts returns for time value and systematic risk

3. Demonstrates the true market return

4. Reflects only the passive investment strategies

The correct answer is: Adjusts returns for time value and systematic risk

Alpha is a measure of the active return on an investment compared to a market index or benchmark. It indicates how much an investment has performed relative to the return expected based on systematic risk, which is measured by beta. When an investment has a positive alpha, it signifies that it has outperformed that benchmark after adjusting for risk. The option that speaks to the advantage of alpha effectively highlights its role in providing a clearer picture of investment performance by adjusting for time value and the associated systematic risk. This means that an investor can discern whether the returns are a result of the investor's skillful management or simply a reflection of market movements. Alpha thus helps investors identify superior investment strategies and managers who create additional value beyond what would be expected from market risk alone. In contrast, avoiding systematic risk, demonstrating true market return, and reflecting only passive investment strategies do not accurately capture the essence of what alpha represents in investment analysis. Each of these options fails to convey how alpha provides insights into the effectiveness of active management relative to risk-adjusted expectations.