“Peak Alpha” Theory: Perspectives from Around the Blogosphere
Oct 7th, 2006 | Filed under: CAPM / Alpha TheoryThe past week has served up a good helping of blog chatter on the topic of alpha finiteness, both in response to and coincident with Alpha Male’s recent posting Peak Alpha Theory?
In response to Peak Alpha Theory? Steve LeCompte at CXO Advisory says:
I think I might compare alpha sources more broadly to energy (low entropy) sources rather than just oil. Peak man-labor gives way to peak horse-labor to peak wood-burning to peak oil-burning to… We are always looking for the best return on energy investments.
Entropy may provide an even better analogy, because of its direct link to information theory. Private information is a low entropy source. Alpha comes from early exploitation of the release and diffusion of private information throughout the investing environment. Maintaining a high alpha means continually locating sources of significantly private and investing-exploitable information. Are a growing number of information exploiters exhausting the supply of private information sources? Do better information drilling tools make more sources of private information exploitable? Do more and more people participating in a global networked economy create an ever-increasing supply of private information sources?”
Steve has written several postings about alpha. In his October 5 posting Diminishing Returns from Hedge Funds? Or Not? he references a new white paper by Andrea Beltratti of the Universita Bocconi and Claudio Morana of the International Centre of Economic Research that suggests Alpha is not being exhausted by the growth of hedge funds.
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[…] All About Alpha pulls together a number of items on the question of “peak alpha.” […]
Alpha Male
Your comments are great; the blogsite is totally unique. Kudos on your work.
Some clarification on your conclusion to the above piece. Whether you or I are more bullish on the future of active management, that is debatable but overall not of any significance. I think what we can agree on is that the art/science of active management is tough. The game is the ongoing search for new sources of alpha (your comparison to oil is spot on) as alpha becomes “betaed”. You say “new sources of alpha will always come online to replace them” however I don’t think we’re in a Soros/Trout/Robertson world anymore. The environment is so different (number of participants, speed of capital movement, etc.) that although new sources of alpha may be available, the opportunity for investors to fully participate in its exploitation is unclear. In my opinion, the issue is not the aggregate size of alpha but the actual true alpha realized by each participant. Didn’t our parents always say nothing worthwhile was ever easy?
Point well taken. More participants mean less alpha per participant. I wonder if more participants also lead to more aggregate alpha in the long run? Intuition would say “no” because increasing liquidity should reduce inefficiency. But not necessarily when there are commensurately more niche and emerging markets to play in.
In any event, you’re absolutely right that all the important lessons about investing we probably learned from our parents.
I think it is true that most hedge funds don’t feel threatened by new entrants. Only the most traditional who are really more scared of their own inability to create alpha are usually scared.