Is alpha, the Wall Street term for market-beating returns, sustainable? Or is it a unique, statistical outlier, indistinguishable from random chance?
I have been thinking about this a lot, lately. The relentless drumbeat of negativity about hedge funds, of which I am admittedly acontributor, is the underlying motivation for this line of thought. It has sent me on a hunt for those managers who consistently create alpha.
They are few and far between. You likely know their names. There is a short list of those who have 1) outperformed; 2) over long periods of time, and; 3) manage substantial sums of money. It’s impressive if you are on that list, but discouraging if you seek to invest institutional capital with this group.
This isn’t a secret. Jim Chanos of Kynikos Associates pointed out that 30 years ago there were only about 100 hedge funds and just about all of them created alpha. Today, there are more than 10,000 hedge funds, and it still seems as if only about 100 of them generate alpha.
It isn’t just hedge-fund managers; stock pickers in general (hedge funds, mutual funds, pension funds, etc.) have been having a hard time of it. This is the “Paradox of Skill.” As more and more talented people enter the investment field, there is simply that much less alpha to go around. Financial researcher Larry Swedroe notes that only 2 percent of managers are generating alpha, down from 20 percent a few decades ago. That number seemed likely to keep failing.
Given all of the talent today in the zero-sum game of trading, it just might be statistically impossible for many managers to create alpha. But it would be wrong to say none do. There are a handful who have consistently made money on both a relative and an absolute-return basis. It is just that sustainable, long-term alpha is that rarest of all elements. The vast majority of institutional hedge-fund investors would have been better off (often much better off) with a simple low-cost index portfolio of 60 percent stocks and 40 percent bonds.
Continues at: If You’re Such a Great Investor, Where’s Your Alpha?