Chasing Alpha: Fools Gold!

As an investor you are constantly inundated with information: Where is the market heading, top 5 buys, top 5 sells etc. This clamour will increase in pitch as we approach the end of the year with predictions for which way the market is headed next year, it will roll in to it elections, status of large projects, weather predictions etc. and yet somehow there will still be several unanticipated events – some government falling, attack or sanction by the UN / USA and everything will be abuzz and different to the predictions anyway. This will all be exciting and exhilarating stuff, calling out to all investors to keep watching the latest updates. We have been saying for many years, it makes sense for the media to turn finance and investing into entertainment, to get more eyeballs and therefore advertising big bucks for them. Clearly, it is a self-serving purpose and they are not really doing you any favour.

If you are a regular viewer / subscribed to finance dailies and magazines, you have access to every type of “Expert Advice.” The more frequently you see an investment guru on these interviews and channels doling out recommendations and numbers, the more likely you are convinced that they must have your best interest in mind and it must be true. We discard the information around how many of those recommendations did not go as predicted, what his personal stake may be in any of the recommended stocks etc. This is the classic situation of our brains trying to simplify information to be able to process and make decisions.

What if the media simply reported the following instead “Markets work, all relevant information is already priced in the stocks, therefore, you cannot time the market or stock pick”? It would mean that finance and investments would be reduced to a half hour segment on your daily 7pm news and nothing more. That makes for a poor business case for an entire industry of news anchors, research analysts and investment gurus! The question to ask always is, who are they really helping?

Now we know that markets work, we know that asset allocation, diversification and time in the market are key. Why then do active fund managers continue to thrive? Well, the answer is the promised pot of gold, the buzzword Alpha.

What is alpha? Very simply, alpha is the return from a portfolio more than the return that would be expected for the level of risk (volatility) taken. Now I put forth to you the simple equation which has stood the test of time and is based on years of research and academic rigour. “Risk and Return are positively correlated, that is, return is the reward for the risk taken.” Therefore, how do you reconcile being rewarded by extra return without taking the risk? For a great instance of how difficult it is to generate “Alpha” consistently, you only need to look at how many fund managers are now forced to include “Alternative asset classes” such as Gold, private equity, art etc. in their investment portfolio. These assets do not have a predictable risk-return payoff and yet are being included in investment portfolios as great potential return generators. This should ring a warning bell for you. According to Eugene Fama, the father of modern portfolio theory, “Before costs, about 50% (of active funds) beat the index. But that is exactly what you’d expect by chance. You cannot tell luck from skill.” And once you add the much higher fees on top of the performance, the performance is even worse.

So, what should you do? Be wary and mindful of funds promising superlative returns that are claimed to be achieved with low risk, any past outperformance is potentially more a matter of luck than real skill. Remember the basics of investments, asset allocation, diversification and time in market. You have the right, and in fact must insist on being provided investment advice that is rooted in strong academic rigour and quantifiable data rather than current trends, loosely correlated variables or worse still, luck.

Of course, there are ways in which you could optimise the return on your portfolio, which meet and are based on academic research, but that is the subject matter of another blog post. For the moment, I leave you with this quote from Charles Munger (Warren Buffet’s partner & Vice-Chairman of Berkshire Hathaway): “It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.

Niyati Khanna ADFP, Chartered Accountant (ICAI), MBA (Finance & Strategy), is a representative of Alman Partners Pty Ltd, Australian Financial Services Licence No: 222107.

Performance data shown represents past performance or simulated performance. Past performance is no guarantee of future results and current performance may be higher or lower than the performance shown. The investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost.

Note: This material is provided for information only. No account has been taken of the objectives, financial situation or needs of any particular person or entity. Accordingly, to the extent that this material may constitute general financial product advice, investors should, before acting on the advice, consider the appropriateness of the advice, having regard to the investor’s objectives, financial situation and needs. This is not an offer or recommendation to buy or sell securities or other financial products, nor a solicitation for deposits or other business, whether directly or indirectly.