The Future of Active Management

CAPM / Alpha Theory 05 Jul 2006

By: Baton Waring, Barclays Global Investors


“Every portfolio has a beta component and an alpha component. In the sense that beta really is about benchmarks that represent market returns, all investing is benchmark relative investing! This is unavoidable. The protests from traditionalists notwithstanding, any and every portfolio can be and should be thought of as some combination of beta and alpha, and the obvious and useful consequence is that all investments must and should be done on a benchmark-relative basis. This should not be protested but embraced, and it is embraced by the best and most modern active managers and plan sponsors.

“Here is the important distinction: Alpha, on the other hand, is only conditionally  rewarded, and therefore, the expected alpha return is only conditionally different from its normal or unconditional expected return, which means that it will have a return of only zero percent! From the efficient market hypothesis, the unconditional expectancy for alpha is zero because the markets tend toward efficiency. The markets are a zero-sum game—a negative-sum game after fees and costs.

“Under what conditions is alpha different from zero? The conditions that allow a positive expected alpha that are still consistent with modern portfolio theory are (1) some degree of inefficiency in the market plus (2) some extraordinary or above-average level of skill. Both factors must be present for the investor to have a positive expected alpha. The important conclusion is that, although we have to recognize that having a true expected alpha is one of the hardest things in finance (and, in fact, across all investors the average expected alpha must be zero), for the most skilled, a positive expected alpha can indeed exist.”

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