Is Alpha Just a Marketing Gimmick?
How do you select an investment manager? Or, if you want to invest yourself, how do you pick a mutual fund, an ETF, or decide which stock to buy?
Once you’ve made your selection, how do you assess whether it’s performing properly? How do you know you’ve made the right decision?
These are the questions that have you reading newsletters. Whether you are doing it yourself or have hired someone to handle investing for you, you want to know if you’ve made a good decision.
How do you know?
I’ve managed stock portfolios for over three decades now. I’ve seen a lot. But trust me, I do not state this so you simply defer to experience. I mention my years in this business to set the stage for some observations that only experience brings.
Not everyone is seeking the same thing from their portfolio. The scale of expectations goes from the absolute preservation of capital on the one end, to consistently outperforming the stock market on the other. These expectations rank the “risk tolerance” of an investor.
Once you know who you are, you’ll head down a path toward certain types of investments. The conservative, risk-avoiding investor tends to follow a path filled with cash and fixed-income securities. The aggressive investor typically walks toward stocks and other equity investments.
Both paths, however, are filled with choices… which brings us back to our original question: who do you hire, or what do you buy?
Financial literature purports to offer you tools to help with your decision. The two measures that are often touted as the answer are: beta and alpha. In theory and together, these measures encapsulate the relative volatility (aka risk), and excess return offered by any investment. Both are applied to both individual securities and pooled invested products like mutual funds, ETFs, and individually managed portfolios.
I’d suggest you be very careful relying on either when making your decisions.
Beta is a measure of the relative price volatility of an investment. If the investment’s price moves up and down more than the market, it’s riskier and is said to have a high beta. Conversely, if its price is more stable than the market, it is said to have a low beta and be more conservative.
I would contend that a historical measure of beta has no bearing on what you should expect from an investment.
Take, for instance, an individual stock, and let’s use an oil and gas company for example. If, for a period of many years, the price of oil and gas is relatively stable and the prospects for the company are relatively constant, we would expect the company’s stock to be similarly stable.
If, over the years, investors come to believe that these stable times for the oil and gas industry are here forever, the stability in the company’s stock will likely be reinforced by expectations.
If this goes on for 5 or 10 years, our oil and gas company will soon be touted as a “low beta,” relatively conservative equity investment.
Is it?
So long as the conditions underlying current expectations remain in place. But once they start to change, so will the price volatility of the stock and with it, its beta.
I could give example after example of what I’ve seen over the years. The long and short of beta as a measure is this: it tells you what has happened and what will happen, so long as nothing changes. In my world, things are always changing.
So, I don’t look at beta. I look at the underlying expectations encapsulated in a stock’s price and render judgement on its probability of continuing. In academic speak, beta is a dependent variable, not an independent measure. Therefore it’s of no help in your decisions.
Alpha is a little trickier to discuss.
The whole migration we’ve seen in the stock market to index products has been driven by a perception of alpha. Remember, alpha is meant to measure the relative performance of an investment. Something that beats the market consistently overtime is said to have a positive alpha. The higher the outperformance, the higher the alpha.
When I was investing money institutionally (which I should point out doesn’t mean I was “institutionalized”, my clients were institutional pools of money) my clients would hire sophisticated consultants to help them make their investment choices. Who to hire? Who to fire? That was their job.
The consultants faced the same problem you face: “how do you decide?” Almost universally, they used statistics to measure beta and alpha. They hire those with good “risk-adjusted” performance. Which meant positive alpha with lower beta. Billions of dollars switch hands based on these measures.
The problem was, neither the beta nor the alpha was stable. Managers would have a few good years and get hired, only to have a few bad years. The measures being employed were leading to turnover and suboptimal results.
The answer became: index the money! Which at least saved the consultants their jobs.
All of this was being reported to the financial press and through them, to the general public. The conclusion became, no one can outperform consistently (i.e. positive alpha cannot be achieved), index investing is a better path.
And that’s been the story of the markets over the past 20 years! All sorts of index products have arisen and they’ve been some of the most popular vehicles for investor’s money.
But what about alpha?
I started laughing when I saw that commercial from Wisdom Tree. One of the firm’s spokespeople and Wharton professor (note: beware of the academics) Jeremy Siegel was telling me that he liked the indexed Exchange Traded Funds (ETF), but not a “market cap weighted ETF.” He’s devised the Modern Alpha ETFs.
Siegel contends (in the ad) that fundamentals can lead to outperformance according to his research, so why structure a portfolio using market cap when there is apparently a better way?
Well folks, we’ve come full circle. What he’s described is not in any way index investing, it’s the good old active management that supposedly can’t generate alpha. He’s just doing it in something that sounds like an index, an ETF.
What’s the problem with alpha? Its patience. That was the problem with the consultants, they were constantly measuring for a sprint in what was actually a marathon. Patience is key.
The market runs through all sorts of cycles, some cycles go on for a few weeks or months, others go on for years. Each cycle is defined by a preference on the part of investors for a particular kind of stock. Many cycles are named for that preference. The “nifty fifty” of the ‘60’s, the “internet boom (bubble)” in the ‘90’s, and more recently FANG.
During these cycles, those investors who loaded up on what was working started showing very high alphas. However, when the cycles turn, few exit in time and alpha collapses. Much like beta, alpha becomes a measure dependent on specific conditions and not a measure of lasting success.
Where does that leave us? How do you make your decisions? There is no simple answer, but I do know that successful investing starts with fundamental research. You have to know what you are buying and why. It’s important because all of us will make wrong choices. The key is knowing when to move on. That’s harder when you hire someone else, as you can’t assess the reasons for performance variance. It’s easier with stocks… if you do the work.
Any well-constructed portfolio has a mix of investment types, holding both bond and equity investments. As important, within each investment type, there will be a diversified mix of holdings. Each bought on its own merits but representing a broad swath of the economy. Diversification at all levels in fundamentally well positioned investments is what drives long-term success.
Admittedly I didn’t give you an easy answer to my opening questions because there’s no easy answer, and I’m trying to convince you not to look for one. It’ll lead you down the wrong path.
I’m glad to share more personally over the phone. Give me a call anytime and we can discuss the very interesting concept of Alpha.