Bloomberg’s Chet Currier is generally in tune with alpha-centric investing. In a column last fall, he quite correctly observed:
The very model of a mutual fund is indeed outmoded, argues a large and growing group of financial researchers and professional money managers who are busy describing, building and proselytizing for a different way of doing things…The alpha-beta community already has been years in the growing. It will be years more before it penetrates, say, the 401(k) retirement-savings market where mutual funds reign now. But a real challenge has been laid down, and it isn’t going away.
But he has thrown out the baby with the bathwater in his latest critique of active management. Earlier this month, Currier referred to alpha as a “mirage”. His thesis:
“…pure alpha may prove an illusory quest. The pursuit of it twists the original purposes of investing, and turns it into a game most players can’t win.”
The Bathwater: Alternative Beta
Before we take issue with this generalization, here’s what we agree on: Currier is absolutely right when he links alpha-centric investing to the emergence of hedge funds:
“An active manager only began to earn his keep when his results emerged from the beta background and began to produce alpha…This way of looking at things contributed mightily to the boom in hedge funds. While many standard long-only mutual funds are effectively fettered to the indexes they try to beat, hedge funds are free to pursue pure alpha from whatever angle they wish…”
This, we argue, is why hedge funds are not a fad, but a fundamental step forward in the evolution of asset management.
We also agree with Currier that alpha morphs into beta as previously unknown information (and trading strategies) become widely adopted. And yes, “hedge fund replication” illustrates that what was once believed to be alpha may be partly alternative beta.
The Baby: Pure Alpha
But branding alpha a simple “illusion” is a dramatic misrepresentation.
The heart of the problem is Currier’s use of a popular, yet inaccurate mining analogy to describe beta. He says:
“Imagine a mineral deposit where 10 miners are extracting silver, all at the same market-equaling return. An 11th party, noticing something the others are missing, begins bringing out gold. At first the extra payoff from the gold is almost all alpha…In short order, the other miners begin going after the gold as well. By the time everybody is mining it, the rewards to be had from the gold have completely dissolved into beta.”
This analogy assumes alpha is finite. But in actuality, markets are constantly evolving. New geographies, new securities and new inefficiencies replenish the global alpha opportunity as quickly as it can be arbitraged away. Obviously anticipating this counter-argument, Currier continues:
“Okay, you may say, the market-beating miner now moves on to platinum. As long as he stays a step ahead of the rest, alpha shall be his. Alas, there are only so many metallic elements in the periodic table…”
Sure, there may be a finite number of elements on the periodic table, but alpha is created from constantly evolving market inefficiencies mixed with inexhaustible human ingenuity. Proclaiming the end of alpha is like saying that all the music than can be written has been written. It reminds us of the famous prophecy attributed to Charles Duell, Commissioner of the US Patent Office in 1899, “Everything that can be invented has been invented.”
Even if markets for many individual securities are efficient, inefficiencies can also exist on a macro scale. In a recent interview, Peter Bernstein characterized markets as “macro-inefficient”:
“The market is hard to beat. Nobody says it isn’t. But the markets are macro-inefficient and this means that risk and return for the market as a whole can go haywire.”
Alexander Ineichen echoes this assertion in his book Asymmetric Returns. Ineichen recently told All About Alpha:
“I believe you can view the tech bubble of the 1990’s as a massive market inefficiency. But (on the other hand) inefficiencies in smaller markets can be arbitraged away much easier and faster.”
Cleaning the Baby: the original purpose of the bathwater
We are prepared to give Currier some slack because he is obviously a believer in alpha/beta bifurcation. We also accept many of his concerns about the pursuit of alpha (“most player can’t win” – after fees). But we just can’t get around the populist tone (e.g. alpha “in the hands of a few elite”) and his apparent belief that the “original purpose of investing” doesn’t include trying to generate alpha. On the contrary, the pursuit of alpha was the original purpose of investing.
– Alpha Male