Since it is a Friday (following Valentine’s Day), I want to step back from the usual market gyrations to discuss a broader topic: The pursuit of Alpha, where it goes wrong, and the actual cost in Beta.

For those of you unfamiliar with the Wall Street’s Greek nomenclature, a quick (and oversimplified) primer: When we refer to Beta (β), we are referencing a portfolio’s correlation to its benchmark returns, both directionally and in terms of magnitude.

We use a scale of 0-1. Let’s say your benchmark is the S&P500 — it has a β = 1. Something uncorrelated does what it does regardless of what the SPX does, and its Beta is = 0. We can also use negative numbers, so a Beta of minus 1 (-1) does the exact opposite of the benchmark.

Beta measures how closely your investments perform relative to your benchmark. If you were to do nothing else but buy that benchmark index (i.e., S&P500), you will have captured Beta (for these purposes, I am ignoring volatility).

The other Greek letter we want to mention is Alpha (α). Alpha is the risk-adjusted return of active management for any investment. The goal of active management is through a combination of stock/sector selection, market timing, hedging, leverage, etc. is to beat the market. This can be described as generating Alpha.

To oversimplify: Alpha is a measure of out-performance over Beta.

Why bring this up today?

Over the past few months, I have been looking at an inordinate number of portfolios and 401(k) plans that have all done pretty poorly. I am not referring to any one quarter of even year, but rather, over the long haul. There is an inherent selection bias built into this group — well performing portfolios don’t have owners considering switching asset managers. But even accounting for that bias, a hefty increase in the sheer number of reviews leads me to wonder about just how widespread the under-performance is.

One of the things that has become so obvious to me over the past few years is how unsuccessful various players in the markets have been in their pursuit of Alpha. We know that 80% or so of mutual fund managers underperform their benchmarks each year. We have seen Morningstar studies that show of the remaining 20%, factor in fees, and that number drops to 1%.

The overall performance of the highest compensated group of managers, the 2%+20% Hedge Fund community, has been similarly awful, as they have underperformed for a decade or more.

All of which leads me to a number of intriguing questions:

• How much does the pursuit of Alpha cost managers in terms of Beta?

• What is the overall drag on investing returns across the entire investing landscape? (Think of the drag on Individual portfolios, retirement accounts, charities)

• What are the literal costs of active versus passive management?

• What proportion of the finance industry exists to either chase Alpha or capitalize on those who do? Consider this in both percentage and dollar terms.

• Are managers consciously aware of the compromise to Beta they risk in the pursuit of Alpha?

I do not know the answer to these, but exploring questions such as these might lead us to some interesting places.

I’ll update this line of thinking in the near future . . .

 

 


Source: Vanguard

 

 

Previously:
How Hard is it to Become the Michael Jordan of Trading? (July 14th, 2011)

Another Mediocre Year (Decade) for Hedge Funds (December 27th, 2012)

Is Anyone Any Good at Picking Hedge Fund Managers? (January 23rd, 2012)

Category: ETFs, Investing, Philosophy

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

27 Responses to “Romancing Alpha (α), Breaking Up with Beta (β)”

  1. Don says:

    There is pressure on hedge fund fees — I imagine performance has something to do with it:

    Average hedge fund fee significantly lower than reported

    Hedge fund industry assets are up slightly from their peak in the 3rd quarter of 2008; however the average fee paid on industry assets has declined much more than reported in industry surveys. These surveys typically show that the stated fee of the average hedge fund has declined very little over the past five years. However we estimate that the average management fee on net assets received by hedge funds since 2008 is 15% lower than commonly believed.

    The hedge fund industry is seeing significant fee pressure from many hedge fund investor channels. These include: managed account platforms, ‘40 Act funds, UCITS, hedge fund seeding and acceleration companies, first loss investors, founders share investors and large institutional investors. These various channels have attracted a majority of hedge fund flows since 2008 and represent a growing percentage of the hedge fund industry

  2. BITFU Search Engine says:

    ie What would happen to the benchmark performance if investors could ONLY buy the overall market with no adventures into individual allocations?

    People would be much more sensitive to interest rates, currency risk and other macro factors that’s for damn sure.

    “What proportion of the finance industry exists to either chase Alpha or capitalize on those who do?” The answer is inversely proportional to the number in finance pros who take those management fees and actually buy the recommendations they are selling.

  3. “…leads me to wonder about just how widespread the under-performance is…”

    from the MutFund Industry?

    it is _______ Massive.

    to your, later, Point..”…We know that 80% or so of mutual fund managers underperform their benchmarks each year. We have seen Morningstar studies that show of the remaining 20%, factor in fees, and that number drops to 1%…”

    which, really, should be re-Read..

    “…We know that 80% or so of mutual fund managers underperform their benchmarks each year. We have seen Morningstar studies that show of the remaining 20%, factor in fees, and that number drops to 1%…”
    ~~~

    Is there, really, another Industry that Costs so much, and Delivers so little?

    Personally, I can’t think of one..
    ~~~

    • What is the overall drag on investing returns across the entire investing landscape? (Think of the drag on Individual portfolios, retirement accounts, charities)

    it deforms Today, and retards Tomorrow.

    though, with this..

    • Are managers consciously aware of the compromise to Beta they risk in the pursuit of Alpha?

    What could make you begin to think that they, even, care (a single whit)?

    One would have to be, Aggressively, willfully negligent not to be aware of it/that Fact..

    Gee, who is Jack Bogle?

    http://search.yippy.com/search?input-form=clusty-simple&v%3Asources=webplus-ns-aaf&v%3Aproject=clusty&query=Jack+Bogle

  4. capitalistic says:

    “Alpha is a measure of out-performance over Beta” .

    Not to be a prick, but that is quite a simplification.

    ~~~

    BR: Hence, the preface “To oversimplify.”

    If we discuss risk adjusted returns, volatility & Sharpe ratio, I lose half of the readers. But the definition does not impact the key issue: With so many managers under-performing, why even bother?

  5. rallip3 says:

    But maybe, just maybe, the community of alpha-seeking active managers actually increase the return and reduce the volatility of the whole market. So if we all resort to indexation, we may find that average returns go down and volatility rises.

    Problem: how can we test such a thesis in real life?

    Second question: How come no investment fund (as far as I know) bases its remuneration on some alpha-based formula?

  6. Gnatman says:

    This (DIESEL – dividends, interest, and equity select liquidations) system claims that a retiree can have a 7% withdrawal rate With a 3% annual inflation adjustment. Sounds vastly different than the universal 4% withdrawal being hawked in all retirement recommendations.

    Randomized failure rate was smaller than all other studied systems (9.1%)

  7. Matt P. says:

    What Mark E. Hoffer said. Beautiful. The entire mutual fund/hedge fund industry is the biggest scam on planet earth. Ackman should be pounding the table regarding the SEC cracking down on that rather than Herbalife. :-)

  8. umbro says:

    Barry, can you reference the study that says that only 1% of active managers beat the benchmarks?

    ~~~

    BR: Yes, I posted on it previously — I’ll try to dig up the original

  9. kek says:

    Great post Barry. I find the Vanguard graphic revealing. Our industry focuses so much on performance, especially in the short term, while ignoring the main factor of poor long term performance, investor/advisor behavior.

  10. tshelton12 says:

    As a CFP and portfolio manager to 100 high net worth families, I can assure you it is extremely difficult to outperform the benchmark net of fees on a yearly basis. But if I am doing my job right, that’s not what clients pay me for. They pay me to not let them make the hundreds of mistakes everyday people make in their portfolio..like…concentrated positions, buying based on emotion, paying a hedge fund manager 2/20 for the “priviledge” of being in the club, selling into fear, etc, etc. etc.

    But even more important, they pay me to guide them to their end goal. That means making sure they don’t pay uncle same too much, protecting their family from undue risk, making sure they live within their means and save more than they would on their own.

    To the point of this article, there is absolutely no reason most investors should not be using ETF’s for 90% of their portfolio. The math just doesn’t add up to own most mutual funds.

  11. Zungstache says:

    Thank you for finally addressing this issue.

    I have a generic 401k that just has a few thousand in it from a job I did not stay at very long with the state of Michigan and whenever I receive a statement I am just appalled at its performance (not appalled enough to actually get around to moving the money out of the account… that would take effort and I’m stupidly optimistic that the clown running the fund will figure out what he’s doing). I’ve often thought of e-mailing a copy of my statement to you as an example of how badly managed the generic “brand name” 401Ks actually are. Remember, this is a plan that is offered by a large state with tens of thousands of employees, not a mom-and-pop company.

    My point is that out here in the real world, average individuals have no conception of how badly managed their 401Ks actually are. If their accounts go up, yippee, and if they go down, well Wall Street must have had a bad year. Concepts such as relative performance are just lost on the average individual. A 401K is what you do to put money aside from retirement to replace the pension plan that the company used to have… and that’s about as much thought as anyone gives it.

    So bravo for pointing this out. I doubt anything will come of it, but at least it’s comforting to know that someone in the financial services industry recognizes this as a problem… and not just another scam he needs to get in on.

  12. [...] Ritholtz of Fusion IQ has an excellent explanation of Beta and Alpha on his overwhelmingly useful blog, The Big [...]

  13. mle detroit says:

    When your exploration leads you to the guru at the top of the mountain — Paul Farrell recommending the Coffeehouse Portfolio — let us know.

    Granted, I was lucky to retire at the end of 2009 and roll over my 401(k) in January and April 2010 from my employer’s expensive management firm to a Vanguard traditional IRA. It all went into as close a match to Coffeehouse as I could find among Vanguard’s (mostly index) funds, and it’s done well — 11.8% total return net of fees last year. Now I’m resisting temptation to reduce the bond allocation. I’m happy to hide and watch.

  14. Matt P. says:

    “They pay me to not let them make the hundreds of mistakes everyday people make in their portfolio..like…concentrated positions, buying based on emotion, paying a hedge fund manager 2/20 for the “priviledge” of being in the club, selling into fear, etc, etc. etc.”

    This is absolutely valid for the top 2% but for virtually everyone else there is simply this. All automatic and all low fee.

    80% stocks and 20% bonds in VASGX
    60% stocks and 40% bonds in VSMGX
    40% stocks and 60% bonds in VSCGX
    20% stocks and 80% bonds in VASIX

    For those with a bit more assets and/or poor 401(k) plans. Use a total bond fund in your sheltered account (or Pimco more likely), and a split between total US and total international. Perhaps some TIPS, munis (for tax reasons), REIT, small cap value if you want to slice and dice.

    Rebalance once every year or two. There you have it. If you can’t stick to it, pay an advisor hourly and don’t do anything until you speak with that advisor.

  15. smartass says:

    This is an issue that will never be fixed as long as the investing public continues to bury their head in the sand.
    After 10 years in the business I have come to the conclusion that fund managers are 1 sided. They believe clients want them to be fully invested at all times so they are good at taking risk. Since they are oblivious to risk they make some horrible calls and don’t worry to much because it will all work out in the LONG TERM. Their compensation encourges this also, deviate too far from your benchmark and you will be penalized, so most funds are closet indexers. Overlap is horrible at most fund shops and they’re proud of low turnover, great I’m paying you to 4x more than ETFs just to hold mostly what the index has. I understand the flipside if they trad too much it would raise cost but that would not be an issue if they were adding value/alpha.

    Mostly comes down to funds being greedy, they should close funds to maximize performance but they would reduce revenue. Look at the performance of closed funds, it is great! The consumer also has some blame in this. They dump record amounts of money into funds when prices are at/near the highest level and pull money when the market is down. This forces managers to buy when prices are too high and sell when they shouldn’t in order to meet redemption requests.

    People need to expand their portfolios and look for equity alternatives. ( I don’t mean hedge funds) These portfolios are static meaning they do not look to take advantage of market mispricings which normally only happen near tops/bottoms/or panics. They use the same mix through thick and thin. They can’t make changes since they are too busy managing their sales organization!

  16. [...] Just how much is your pursuit of alpha costing your portfolio?  (Big Picture) [...]

  17. DHM says:

    Lot’s of great comments in this thread.

    The idea that the common person can make smart investment choices using active management strategies is of course silly. It reminds me of the idea floated by the Bushies back in the early 2000s – namely releasing some SS funds to allow individuals to self-direct. I bet that hair-brained idea is still residing in some right-wing think tank.

  18. bonzo says:

    There is a justification for fees on the order of 1% of assets for small investors, because many small investors tend to be excessively conservative (all money-market funds) or to performance chase. A manager who can prevent the small investor from making those basic mistakes earns his fees, given that the equity premium should be at least 3% over the short-term rate, in the long run, and buying-high, selling-low is worth Gods only knows how many percentage points.

    What I find remarkable is that supposedly sophisticated investors (pension fund directors, endowment fund managers) use hedge funds. This is unsustainable. My long-standing prediction is that the final bear market bottom will occur when there is massive revulsion against hedge funds.

    Hedge fund managers tends to be very intelligent, but they are severely handicapped by being forced to take a short-term orientation due to client pressure, This ultimately causes them to become dumb money. After the shakeout, the better hedge fund managers will go to work managing their own money, and they’ll earn lots of alpha and in the process bring the market back to efficiency, but the heady days of 2/20 on massive AUM will be over for most of these guys.

  19. This is what I dug up so far

    How Expense Ratios and Star Ratings Predict Success
    http://news.morningstar.com/articlenet/article.aspx?id=347327

  20. umbro says:

    This is helpful, although I didn’t see them talking specifically about performance relative to benchmarks. I agree that active manager may slightly under-perform benchmarks as a group “after fees”, but saying that only 20% or even 1% outperform seems a bit severe and unlikely to me.

  21. bonzo says:

    This discussion is all over the map, with everyone answering different questions, but anyway, the classic discussion of the cost of active management is by Ken French:

    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1105775

    I read this long ago and don’t feel like reading again, but the abstract says active mgmt costs are about 67 basis points/year of market value, or something like $100 billion. John Bogle throws around $200 billion and $300 billion and even higher figures, but then Bogle is getting on in years. French’s $100 billion is more realistic.

    At an average salary of $200K (including all the computer peons and copy machine repairmen and whatnot who make far less than $200K plus the hedge fund managers and Goldman Sachs execs who make much more), $100 billion suggests something like 500,000 people owe their salaries directly to finance intermediation, and then millions more would be indirectly supported by this “industry”. I suppose it’s better than if this huge army was put to work fighting wars, though perhaps not so good as if they were digging holes in the ground and filling them back up again.

  22. [...] The awful cost of pursuing alpha – The Big Picture [...]

  23. investorinpa says:

    Barry, I don’t know if this data exists or not, but is there any research comparing the following:

    Returns of individual IRA vs. employee sponsored 401K plan vs. Self Directed IRA plan vs. Pension based plans.

    Just curious if anyone has done that research ,or if they are correlated or not. Several of my friends in the RE business are doing VERY well with self directed IRA’s as they use their old 401K or IRA money and do loans of 8-15% or buy real estate with that. Thank you.

  24. ToNYC says:

    Is this not a case of trying to have your cake and eat it too?
    If I must have the prom Queen or Alpha male, I have broken from the beta pack.
    Uncertainty is risk and risk is opportunity.
    Don’t act until certainty, and leave the rest to me.

  25. [...] Ritholtz of Fusion IQ has an excellent explanation of Beta and Alpha on his overwhelmingly useful blog, The Big [...]

  26. [...] average after expenses they underperform their respective benchmarks. Similarly Barry Ritholtz at The Big Picture writes: One of the things that has become so obvious to me over the past few years is [...]