The entire purpose of asset management is to create alpha. Active asset management started some 70 years ago, and has grown significantly in that time
The entire purpose of asset management is to create alpha. Active asset management started some 70 years ago, and has grown significantly in that time
The entire purpose of asset management is to create alpha. Active asset management started some 70 years ago, and has grown significantly in that time
In the early days when the information was difficult to obtain, achieving alpha was a much easier goal. Warren Buffett regularly posted annualised returns of over 30% in his first two decades of investing. As recently as the 1990s there were a few hedge fund managers who also posted annual returns of 30%+ after fees.
But we have a major problem: alpha is disappearing. And investors have noticed, flocking in droves away from actively managed funds and into ETFs.
Alpha is the excess return above the market’s return, also known as beta. Beta can be easily achieved by simply buying an index via an exchange-traded fund (ETF).
Even Buffett, as the most successful investor ever by the total wealth accumulated, has underperformed the S&P500 ETF for the last 17 years (achieving a 9.13% return vs. the market’s 10.13%). The gap becomes wider as the starting point is moved closer. Since 2008, 7.37% vs. the market’s 9.93%, and over the last five years, 11.71% vs. the market’s 15.25%.
What has caused this, and what can investors do about it? The internet has increased the availability of information about financial markets tremendously, resulting in an extremely efficient marketplace. In every market, financial or otherwise, as more information becomes widely available, the value of an asset and its price converge, so it becomes more difficult to find undervalued assets. Financial markets have effectively become a perfect market, so the difference between value and price has fallen to zero.
When a transaction is done between only two people and there is an asymmetry of information, the market is not efficient. The party with better information has a clear advantage. Selling a used car is a good example. The seller has much better information about the true value of the used car than the buyer, so the transacted price is likely to be above fair value. If we add more information, say a mechanic’s assessment of the used car, the final transacted price will be much closer to the true value of the car.
In the early years of asset management, value investing was one of the favored investing styles. Information about companies was not easily available and analysing a company’s fundamentals involved a considerable amount of work. In such an environment, stocks could be found which traded well below the intrinsic value of the business, and in some cases even below the cash the company had on its balance sheet. When such undervalued stocks were discovered, a manager could allocate with confidence a large percentage of their portfolio to such stocks.
Today all this data is available to anyone at the click of a few buttons. With millions of computers automatically combing through company data looking for an edge, discovering a stock trading below cash on the balance sheet is virtually impossible. If you were to find such a stock, there’s probably a good reason why it is trading at that price. Any edge in fundamental analysis has diminished tremendously, and active managers are becoming arbitraged out by the market.
This situation is also applicable to trading strategies. Momentum and trend following, extremely successful strategies in the 1970s and 80s, have also been arbitraged out by markets. They have returned zero over the last decade. Any ‘alpha’ generated by a trading strategy is someone else’s loss, and the whole situation has become worse than a zero-sum game after trading costs and slippage are taken into account.
What is an investor to do in this situation? We are being reduced to embracing beta. Even the investment mantra of diversification has become a source of negative alpha, as any diversification into the largest companies (which are currently all tech) resulted in significant underperformance for a decade. And the best way to embrace beta is to simply buy an ETF, as the costs of doing so also converge towards zero. The financial markets have become the most competitive markets in the world, so there is little hope for a sustained alpha generation going forward in strategies that can be scaled up to size.
Are there places where alpha can still be generated? It is unlikely that it can be done in liquid financial markets any longer. An investor who is not satisfied with beta would need to have the courage to venture into the new uncharted and esoteric territory, to develop specialized expertise, all on investments that may not work out. And when the money starts flowing into these esoteric sectors because the markets become more efficient, the alpha there will also start disappearing.
The current second mania in crypto is a good example of this. The early adopters made money by mining new bitcoins, but this has already also been arbitraged away as bitcoin prices rose and electricity needs and costs became too high. Buying bitcoin itself is the beta equivalent of the market, while mining bitcoins was the alpha generation. Venturing into new esoteric territory can be highly rewarding, but the market will also make alpha disappear there once it gains in popularity.
For investors unwilling to take these large risks, embracing beta is the optimal choice. Asia is still behind the US and Europe in the adoption of ETFs, as there is still some alpha generation that can be created here due to less liquid stocks that are not widely followed by analysts. But alpha in this last corner will also drain away as each year passes.
On a related subject, I often give lectures to graduating classes to attempt, usually unsuccessfully, to dissuade them from entering finance as a career. Years ago I was discussing the topic with a fellow fund manager, where finance has been a massive brain drain on the world’s economy, luring the best and brightest young minds in devoting all their hours in a zero-sum game, instead of making new discoveries and inventing new things that are actually useful to the world. Competition reduces profits. Perfect competition reduces profits perfectly, to zero.
By LEONARDO DRAGO
Co-founder of AL Wealth Partners, an independent Singapore-based company providing investment and fund management services to endowments and family offices, and wealth-advisory services to accredited individual investors.
