In performance measurement, how should a portfolio be evaluated using benchmarks and alpha?

• A. Compare realized returns to a relevant benchmark and compute alpha as the risk-adjusted excess return.
• B. Only compute alpha and ignore benchmarks.
• C. Rely solely on raw total return, ignoring risk.
• D. Use beta as the sole measure of portfolio performance.

Answer: (A)

Evaluating performance hinges on comparing what the portfolio earned to what its risk level should have earned, using a benchmark as the reference and alpha as the measure of risk-adjusted value added. A relevant benchmark reflects the market or asset-class exposure the portfolio aims to capture, so it provides the standard against which performance can be judged. Alpha then represents the part of the return that cannot be explained by the portfolio’s exposure to risk, calculated as the actual return minus the expected return given that risk. The expected return comes from a model like CAPM, where expected return equals the risk-free rate plus beta times the market's excess return. A positive alpha means the manager added value beyond the risk taken; a negative alpha means underperformance after accounting for risk.

This approach beats relying on just alpha or just raw returns. Using alpha without a benchmark leaves you without a reference point to judge whether the return is due to skill or simply taking on more risk. Focusing only on raw total return ignores how much risk produced that return, which can be misleading. Using beta alone tells you how sensitive the portfolio is to market moves but doesn’t quantify whether those moves translated into extra value beyond the expected risk-adjusted return.