A Mass of Alpha

CAPM / Alpha Theory 28 Sep 2006

By: John Mauldin
Published: May 9, 2004

Alpha Male just came across this little ditty from the prophet-cum-best-selling-author John Mauldin.  In his weekly newsletter, Mauldin refers to a panel he moderated in the spring of 2004 involving several high profile financial speakers.  Panelist Mark Finn, CEO of Vantage Consulting, delivered what Mauldin calls a “blitzkrieg of investment wisdom that may take you days to absorb”.  Finn’s presentation was All About Alpha.

To help him survive this “blitzkrieg”, Mauldin uses Duke professor Campbell Harvey’s dictionary of financial hyperlinks to review the definitions of Alpha & Beta.  (Alpha Male has been a huge fan of Harvey – and of Duke – since attending business school at that hallowed institution).  Mauldin goes on to describe Mark Finn’s view of alpha:

“For Mark, alpha is an evolving mass. It is the return that can be captured by innovation and skill, but Mark thinks that in the short run there is a finite quantity of alpha (or excess return) in any given market, with every skill-based manager chasing and trying to capture some of this finite amount of alpha.”

Finn says that while alpha often morphs, its size remains constant:

“Alpha according to Mark can be thought of as a mass of bees flying through the countryside, constantly changing shape, but essentially staying relatively the same size.”

Apparently, Finn was just getting rolling though.  According to Mauldin, Finn went on to draw an insightful parallel between alpha and quantum physics:

“Mark likes to think of the amount of total alpha as a “quantum amount.” In quantum theory, the definition of or the observation of a thing can change the reality of the thing being defined. Defining or observing alpha in a market can change the amount of alpha available. Remember my statement above? “…the alpha gets arbitraged away because of too many managers chasing a finite amount of alpha. The very act of chasing the alpha lessens the amount of alpha available.” Simply mass observations and chasing the alpha changes the nature and quantity of the alpha, so the analogy to quantum theory is an accurate comparison.”

“I agree there may be technical limits to alpha, but right now I think it is like saying that there are limits to oil production. We all know in the future, that oil is going to become a scarce quantity. Depending upon who you read last, that could be the next decade or the next five decades. Yes, we have seen the top of oil production in the US. The large fields are all found, but small firms are still finding oil in odd and out-of the-way places. And there are huge sources of oil being found around the world.”

Alpha Male agrees that, like oil, there will always be new sources of alpha to exploit.  But the oil metaphor does have its limitations.  In this post on why the search for alpha is more like baseball than drilling for oil, Alpha Male argues:

“Unlike oil, alpha was not left to us en masse by Mother Nature. There is no finite amount of alpha in the world ready for us to exploit. Alpha is situational, transitory, and relative. It has no physical dimensions and cannot be measured directly.”

According to Alpha Male, you can’t compare alpha to oil on the one hand and then argue that it’s quantum dynamics mean cannot be measured directly on the other.  Oil can be measured directly.  But alpha (market inefficiency) can only be measured by its effect on returns – like measuring the size of an extra-solar planet by the size of the wobble in its sun – or the amount of oil produced in the world based on global warming paterns.  Still, Alpha Male lacked the congnitive ability to close the loop and draw the quantum physics parallel himself.  So we sent him to bed with no story.

Oil is a loaded metaphor for alpha that raises several questions:  Will alpha ever run out?  Is there a demand curve for alpha?  And most importantly, is there a supply curve for alpha.  Mauldin seems to suggest alpha does have a supply curve and that new sources will require greater and greater investment to exploit.  The $1.2 trillion question for the hedge fund industry is: will the required investment only be made if the equilibrium price is high enough?  Stay tuned. 

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