In Finance 101, we learn of the efficient market hypothesis and its assertion that asset prices fully reflect all known information, and its corollary, that trying to beat the market is futile. And yet there are thousands of managed products that attempt to do just that. Most fail, as it’s widely understood that generating alpha is a zero-sum game even before fees and taxes. As a result, we’ve seen the rise of passive investing, the thinking being, “Control what you can control — cost — and let the chips fall where they may.”
Interestingly, over the same time that passive approaches have grown in prominence, so too has our understanding of how we make decisions under the cloud of uncertainty and when staring down the ravenous eyes of risk. This expansion of knowledge can be credited to the work of a collection of disciplines that fall under the “Behavioral Economics” label. The website BehaviouralFinance.net catalogs well over 100 distinct behavioral flaws, from the widely accepted, like “Loss Aversion” and “Anchoring,” to the lesser known, like “Touchy-Feely Syndrome” (admittedly a new one for us).
We’ve observed that as the asset management business has flourished, and as client needs have become more clearly delineated, the size and structure of investment programs have added to the inefficiencies discovered through cognitive psychology. Take for example the situation where, per investment policy statement, managers are prevented from owning debt that isn’t investment-grade; when a bond is downgraded below BBB, those managers are forced to sell. Or consider the plight of massive equity funds that have to put tens of billions of dollars to work and are terrified of considering smaller and less liquid names, no matter how appetizing the investment story, for fear of being labeled a “style drifter.”
Beating the market requires that one have a non-consensus view and be right more often than wrong. How that is accomplished, we believe, isn’t simply a matter of better financial statement analysis; there are far too many highly educated individuals in our business who spend all of their time poring over balance sheets. The trick is to identify the reason that the market is mispricing the security; and for that to be true, given how compelling the efficient market hypothesis is, there has to be an identifiable inefficiency that makes it so. To have confidence in the idea, we need to understand both the reason for the inefficiency’s existence and why it should reasonably persist. We refer to this as an alpha thesis.