Professions exist to deliver specific outcomes for their clients. Medical professionals cure the sick. Accountants ensure the accuracy of financial statements. Asset managers produce alpha; this is our business.
But while the term “alpha” is widely used, in our experience, it's not particularly well understood. Alpha, properly defined, is return in excess of what could have been expected given the risks assumed. Notice that this is not strictly outperformance relative to a benchmark; rather, it's relative performance given the level of risk taken.
The outcomes attributable to the efforts of investment professionals are admittedly more difficult to measure and judge than they are in medicine, for example. Further, over the past couple of decades, the tools and techniques that we use to measure performance, along with the increased availability and quality of data sets, show us that much of what we used to view as alpha was actually systematic exposure to a particular factor.
Granted, 10 to 15 years ago investors had little in the way of vehicles to harvest premiums to value or quality or low volatility, for example. Active managers who correctly divined that companies and stocks exhibiting those qualities offered excess risk-adjusted returns were rewarded. That was certainly alpha at the time because it took skill to identify the opportunity and to build a portfolio that capitalized on it while managing risk.
Today, those same risk premia can be harvested systematically and cheaply, and therefore calling them “alpha” is a stretch. So does alpha still exist?
Where to Find Alpha Today
At a time when the popularity of indexing has reached levels akin to Beatlemania, investors certainly seem to be saying that either alpha doesn't exist or that it's too difficult to identify managers on an ex ante basis who can produce it.
The standard bearers of this new world arguably aren't in the same business as the rest of us. With every dollar raised in passive investment vehicles, these giant firms take another step toward exiting the investment business. After all, can a firm truly be considered an investment firm when it doesn't make any investment decisions?
How can we as a profession meet our collective obligation to generate alpha for clients? With fewer informational advantages — think Reg FD and the ubiquity of big data and powerful computers — the business must evolve. We believe there is room to identify and exploit inefficiencies, albeit mostly in capacity constrained ways.
For one, behavioral finance has provided a treasure trove of ideas for capitalizing on the biases so clearly exhibited by investors. Whereas in the past an investor's advantage came from better understanding financial statements and industry dynamics, the advantage now is in understanding how investors process and act on that information.
Gravitating toward broader opportunity sets and freeing managers from the tyranny of the benchmark needs to be given serious consideration as well. The flexibility to fully express all views on the securities researched improves investment efficiency because more of the information uncovered is acted upon.
Last but not least, risk management is most certainly an area where thoughtful, skilled investors can add value. Buying companies no matter their valuation or fundamentals, as is the case with indexing, guarantees sub-optimal outcomes when markets inevitably roll over. We’ve lived through two 50% equity market drawdowns since the turn of the century, and it will happen again. Because recovering from a big loss is so difficult, investors would be wise to let their managers add to cash when opportunities are scarce. Or take short positions. Or invest across the capital structure, wherever the payoff to risk is most enticing.
As is the case for all industries seeking to benefit from the forces of creative destruction rather than succumb to the gravitational pull of extinction, the asset management industry must evolve. Our industry has amassed fortunes through cowardly decisions to closet index, and through the abrogation of the responsibility to act when what worked in the past is found no longer to be effective. Investors have had enough and taken their hard earned dollars to passive managers. Generating alpha is our business, and it's time we got back to work.
--- Read Portfolio Management in the Active Equity Renaissance on ThinkAdvisor.