Wednesday, August 10, 2011

The Quest for Alpha

In the investing world, alpha refers to the ability to beat the market. In his book The Quest for Alpha, Larry Swedroe argues strongly that persistent alpha is exceedingly rare and we shouldn’t bother to look for it. He says that investors should use index investing to get market returns with minimum cost. In this way we will actually outperform those who try to beat the market.

Swedroe is big on evidence. He looks at the numbers for mutual funds, pension plans, hedge funds, individual investors, and behavioural finance, and concludes that positive alpha is rare over long periods of time.

For investors who think they can beat the market because they are smart, Swedroe has the amusing example of a Mensa investing club that had lost to the market returns by 13% per year for 15 years. “One investor described their strategy as buy low, sell lower.”

David Swensen is quoted as saying “Individuals who attempt to compete with resource-rich money management organizations simply provide fodder for large institutional cannon.” Decades ago, the percentage of trades performed by institutional investors was low, but in recent years it has risen to 80% or 90%. Active individual investors have stiff competition.

In an interesting study of individual investors’ brokerage accounts, the investors overestimated their own performance by 11.6% per year! Most people lost to the market return but had no idea this was true. It seems that investors would rather protect their egos than their money.

Swedroe accuses both Wall Street and the media of knowing that individual investors can’t beat the market, but brokers make money from helping investors try to beat the market, and media stories about index investing are too boring to bring in readers.

Swedroe offers 30 “prudent rules of investing”. Here are three of them:

“Before acting on seemingly valuable information, ask yourself why you believe that information is not already incorporated into prices.”

“Never work with a commission-based advisor.”

“Keep a diary of your predictions about the market. After a while, you will conclude that you should not act on your ‘insights.’”

When asked about Warren Buffett, Swedroe says that if you see Buffett when you look in the mirror, “go ahead and seek the Holy Grail of alpha.” If not he says you should “play the winner’s game,” meaning low-cost indexing.

The final quote of the book is from Buffett who says that “the stock market serves as a relocation center at which money is moved from the active to the passive.”

Investors who seek alpha for their own investments should read this book and either give up the quest or explain to themselves why Swedroe’s arguments don’t apply to them.


  1. I like reading Larry's insights. A minor pet peeve is his use of the term "loser's game". He takes it to be synonymous with "game you will probably lose", which is not what it means. A "loser's game" is a game which is defined by the mistakes made by the losers (eg. bowling, backgammon, darts) rather than the skill of the winners (eg. javelin, lacrosse). The idea is that seeking alpha is a loser's game, and guys like Buffett succeed because they makes the fewest errors.

  2. The framing of this debate in terms of smart and stupid is a straw man argument.

    Warren Buffett said "The stock market is a wealth transfer mechanism, it transfers wealth from the less informed to the more informed." Note that no mention of being smart is made. In other sayings of his, he says that only a moderate IQ is required to beat the market. You could afford to give the extra IQ points to a needy relative. Smarts,no, hard work, yes.

    The reason the Mensa club people lost money is because of the hubris caused by thinking they were so smart that things like doing investment research are beneath them on account of their being so smart. As a result, they were the less informed.

    Often, as an investor, I am asked by retail investors about what I think about such and such a company. When I ask, "Have you read the annual report?" The answer is usually no and then they try to present me with their armchair analysis as to why they think the stock is a good buy, again, acting in the same manner as the Mensa people.

    Value never seems to be a concept to these people. Once they fall in love with a stock, they would buy it at any price. Or they use price to price instead of price to value as the investment criteria.

  3. Something doesn't quite jive here. Swedroe says, with data evidence, mutual funds, pension funds, hedge funds, all of them PROFESSIONAL INVESTORS, do NOT outperform. Then we move on to the quote from Swensen (and many others are fond of saying the same) that individual retail investors should not attempt to compete with the pros. So who the heck makes any money at all? ... It seems to me that Ahmed is on the right track - people who are a) well-informed, do better. But there is also b) motivated / incented to outperform, which excludes pension funds for the reason that they are mostly bureaucracies concerned with being average and not getting blame, and excludes mutual funds and hedge funds, which are mostly about gathering assets and collecting fees. The really skillful investors are surely almost all doing it for themselves and not offering their talents to the public. To coin a phrase, "those who can, invest, and those who cannot, live off others".

  4. @Patrick: I suspect that Swedroe considers even trying to play the active game to be an error.

    @Ahmed: It's true that most retail investors don't read annual reports. But, the vast majority of dollars are traded by professionals. Presumably they do read annual reports.

    @Canadian Investor: The basic idea is tht everyone can make the market return less modest costs with indexing. Those who try to beat the market incur larger costs, but very few manage to make up for these larger costs over a long period of time.

    Swedroe is examining whether people can beat the market, not whether they can make any money at all.

  5. @Michael:

    Professional investors are constrained by their clients. It has been found in the mutual fund industry that two negative quarters of poor performance and the redemptions start rising. As such, they chase short term performance and that shows in their results.

    And don't forget window dressing. Remember when Nortel was hot and every fund manager had to make sure it appeared on the quarterly statements so they bought without out regard to value. The fund managers can't achieve high performance results because their clients keep sabotaging them.

    Imagine you were a fund manager and spotted bargains in the last few days. You wouldn't be buying because you would be selling to raise cash for redemptions as your clients kept hitting the sell button. And when the market recovers and prices are high and rising, they'll be handing that cash back to you to invest when no bargains can be found.

  6. @Ahmed: All these things are true of some institutional investors. I think Swedroe would argue that we can identify many inefficiencies in the market, but that investors end up unable to exploit them cheaply enough to generate positive alpha.

  7. Hmm, the net of fees part just made me consider something: my passive portfolio has fees of ~40 bp (TD e-series funds). I'll have to double-check, but I believe my active portfolio has fees of ~24 bp, and if I had a larger portfolio or used Questrade I could probably cut that in half again.

    I wonder if the advent of discount brokerages has changed the "net of fees" problem with active investing (not so long ago I'd have been looking at $29 trades, so ~3X the fees, and not so long before that I would measure in % rather than in bp).

    Anyhow, the best data about passive vs. active is for mutual funds, in part because the data is so easy to get and analyze. I wonder if there's data on closed-end funds vs the index (to control for being fully invested/going to cash for redemptions).

    I'm still walking that thin line on the active vs passive debate: I think some investors can beat the index, but that most shouldn't try.

  8. @Potato: It sounds like either your holding period is very long or you put a large sum into each of your picks. Swedroe would likely crticize your active portfolio for being inadequately diversified. Of course, if you actually have the talent to pick stocks well, you don't want to be too diversified.