By Bill Kelly, CEO, CAIA Association
Perhaps the most prescient definition of alpha is simply undiscovered beta, and if you look at this idea through the quinquagenarian endowment model, you might just see the point. In the good old days, investment performance and alpha were one in the same. Along came cap-weighted indices, benchmarks, and equity risk premia, and alpha was more narrowly defined as the premium above that mark. The alpha squeeze was exacerbated even further as other alternative risk premia was mined and defined. That illusive alpha is still there but now in more discrete pockets, and accessing it will require increased levels of due diligence, risk management, thorough analysis, and professional rigor.
The early days of the endowment model had many of the Pavlovian attributes that attracted some of the smartest investor minds of the time: inefficiency, asymmetry (information), illiquidity, and opportunity. However, word eventually got out and the world went from two dozen private market general partners in the early 1980s to now more than 7,000 in the PE space alone according to McKinsey; hard to argue that some of the alpha didn’t morph into beta as efficiency improved, illiquidity premiums shrunk, and opportunities were often bid up by multiple competitors. Performance dispersion widened too, and median returns showed increasingly higher correlations to public market proxies. The DOL and the SEC are also now showing a keen interest toward broader retail access, perhaps inviting even greater transparency (efficiency) and increased liquidity to the traditional PE model. GP selection, geography, middle-market inefficiencies, and the sensible deployment of leverage are just some of the key attributes that should remain top-of-mind for the astute investor.
As we move from the A and the B, does the history of the endowment model portend anything for the Z as in zettabytes or the unit of measurement for big data? Certainly, size is not an issue here as the worldwide data is now up to 50 zettabytes according to IDC which is a doubling from just three years ago, and up from virtually zero back in 2010. This data is largely unstructured (inefficient), asymmetric, mostly nascent in both size and discovery, and replete with opportunity for the patient analyst, particularly the one who has cracked the code to work with the data scientist—the founding premise of the FDP Institute. A recent podcast from our friend Ted Seides puts a bold underscore on this theory as more businesses and investment decisions will need to be model-based in both strategy and approach.
Finally, what does this mean for the end investor who is increasingly more retail, less sophisticated, and under-saved for retirement? According to a recent report from Schroders, the ABZ’s have fundamentally been misunderstood around the world where expectations of average annual returns for the next five years stand at just under 11%. If that sounds unrealistic to you, check your less sanguine views against the averages from over 30 different countries where the parade is led by the US with a 5-year return expectation of over 15%! Alpha, beta, or the deployment of zetta will be hard pressed to square that circle and maybe you should consider dropping The Amazing World of Bubbles elective; then again, that is likely the only conceivable path to such a ‘fantasy island-esque’ outcome.
Seek diversification of portfolio and people, education, and know your risk tolerance. Investing is for the long term.