Chasing the elusive alpha

(Published in the Financial Times on 30 April 2011)

Last week's FTfm reported on a fund industry "overpaid by $1,300bn", citing an unpublished report by the IBM Institute for Business Value.

According to the IBM draft report, $834bn of fees annually are paid to actively managed long-only funds that fail to beat their benchmark, though FTfm believed the figure had been revised down to $300bn. According to the report, "alpha generation" or the ability to deliver index-beating returns, was "pitiful", despite the huge sums paid.

The fact is the ability for the industry as a whole to generate alpha will always be pitiful. Why? In the same spirit as Newton's third law of motion, every outperformer requires an equal and opposite underperformer. Put another way, alpha generation is a zero sum game.

The only way for alpha generation to be positive for the industry as a whole would be for other equity investors such as corporations or governments to underperform. This is possible over short periods but almost certainly impossible over longer ones. Thus it must be accepted that paying fees to the active management industry is in some respects like paying people to toss coins with each other. On the face of it active management is a destroyer not a creator of value.

So why does it survive?

First, its alternative, passive investing, seems inherently un-Darwinian. Being average has never been associated with progress. The active management industry also plays an important role in asset pricing and capital allocation, thus helping to raise beta, the overall market return. And some coin tossers are skilful. With some relatively simple analysis, it is possible to identify them.

Which brings us to the efficient market hypothesis and whether it is possible to beat the market. It is surprising to me that the question of whether market efficiency is strong, semi-strong, weak, or otherwise is always framed in objective terms. Markets are efficient, or not; markets are strongly efficient, or not.

A better way to understand efficiency is to frame the issue in subjective terms. In other words, whether markets are efficient depends on who you are. For most, markets are and always will be 100 per cent efficient. But a privileged few have the skill required to spot inefficiencies big enough to profit from. Indeed the harsh reality is that this privileged group is profiting at the expense of the aforementioned majority.

Of course, all active managers believe they are skilful even though many are not. Such delusion can be explained by the natural human behavioural bias known as the fundamental attribution error, in which we attribute gains to skill and losses to (bad) luck.

Successful investing is about being different. The skilful managers tend to be those who understand that to perform well, and leave enough for clients once fees have been deducted, you need to put yourself in a position to perform well. That means being different from the benchmark.

In theory, a fund that departs significantly from its benchmark has as much chance of lagging it as beating it, but evidence suggests otherwise. According to research by Martin Cremers and Antti Petajisto of Yale University, US mutual funds with high active share (very different to their benchmark) outperformed those with low active share (closet indexers) by 2.5 percentage points a year (from 1990 to 2003).

But if it is that simple, why doesn't everyone simply run high active share funds? Perhaps because such funds are likely to exhibit volatile short-term performance, in some quarters substantially underperforming their benchmark.

The fact is that tracking error is used as a measure of risk and thus seen as something to be minimised. Instead, it should be seen as the cost of good long-term performance, and a small one at that. In sport, winning requires guts. It may be the same in fund management.