Let's assume that we have two hedge fund managers: Kate and Jen. For simplicity, we will assume that the risk-free rate is 0%. Suppose that Kate delivers a 6% annual return, and Jen delivers a 4% annual return. At first glance, Kate is the better manager. But we already know that a comparison based on raw numbers isn't accurate. We need to know how much risk they were taking!

Given that Jen was "market neutral" (i.e., her market beta was zero), and Kate, on the other hand, captured the market premium by betting on stock futures (a market beta of one). If the market return was 3% a year, Kate actually produced only a 3% (6% -1 3% = 3%) annual excess return on the hedged component of her fund, which is less than Jen's at 4% (4% - 03% = 4%). That is, Kate's alpha is 3% and Jen's alpha is 4%. By adding a market component to her hedging strategy, Kate has "changed her context," making her raw returns look better than Jen's.

Alpha is our analytical tool for assessing the context and is the return on the fund minus the appropriate benchmark. It is essentially the same as a deviation from the CAPM. In our simple example, we constructed the benchmark using the CAPM by assuming a simplification of a 0% risk-free rate. Thus, Kate's alpha of 3% (6% 1 3% = 3%). Suppose the third fund manager, Tom, had a return of 7.5% but a beta of 1.5, then his alpha would be 3% as well (7.5% 1.5 3% = 3%). Looking at the alpha instead of the raw returns removes the effect of Kate's and Tom's big market bets.

Since Jen's 4% alpha was superior to Kate's 3%, does it mean that Jen's fund performed better?