What is “Alpha”?

In investment terminology, “alpha” refers to a portfolio’s level of outperformance relative to an appropriate benchmark. Of course, everyone would like to achieve returns above their benchmark. But it is recommended to have a good understanding of the cost and the possibility of achieving alpha before deciding to pursue it.

There are two broad approaches to investment management: active and passive. An active approach seeks to add value, or alpha, by overweighting exposure to stocks believed to be undervalued and underweighting those believed to be overvalued. The obvious goal is to outperform a strategy that simply holds all stocks according to their market weight (ie benchmark portfolio).

Passive investment managers believe that it is highly unlikely that it can reliably outperform the benchmark over the long term (without taking on more risk). Therefore, their focus is not to outperform the benchmark, but to replicate it as cheaply as possible. Its added value consists in providing a diversified portfolio with minimal trading and management costs.

Shouldn’t everyone opt for “Alpha”?

If you knew your additional return would more than offset your additional costs, it would always make sense to try to beat your relevant investment benchmark. The difficulty, however, is that while you know that searching for alpha will increase your costs, you don’t know for sure if it will increase your return. You could end up with additional costs and worse than baseline performance (ie negative alpha).

In fact, it is impossible for all active investors to reach a positive alpha. Let’s look at an example that illustrates this for the two investment approaches described above.

The small and mythical country of Tinyville has only 4 companies on its stock market: Beta, Delta, Gamma and Omega. Company values ​​and their market weights are shown below for “yesterday” and “today”:

companies
passive investors
active investors

Pink
orange
Blue
White
Black
Brown
Total

beta ltd
$14,000
$10,000
$30,000
$25,000
$15,000
$6,000
$100,000

delta ltd
$9,800
$7,000
$25,000
$10,200
$8,000
$10,000
$70,000

gamma ltd
$7,000
$5,000
$15,000
$7,000
$16,000
$0
$50,000

omega
$4,200
$3,000
$10,000
$0
$6,000
$6,800
$30,000

Total
$35,000
$25,000
$80,000
$42,200
$45,000
$22,800
$250,000

Also, there are only six investors in Tinyville: Mr Blue, Mr White, Mr Black, Mr Brown, Mr Pink, and Mr Orange. Pink and Orange are passive investors and therefore their portfolios will reflect market weightings. The other four are active investors, so their portfolios will differ from market weights.

Points to note include:

• The total value of the portfolios of the six investors is (and must always be) equal to the value of the global market;

• The weighted average return of all investors is (and should always be) equal to the total market return;

• Passive investors earned the market return;

• The overall weighted average return of active investors is equal to the return of the market; Y

• Black’s outperformance is offset by the underperformance of the other three active investors.

The “Alpha” bet may not be the smartest

The findings of our mythical market apply to real stock markets. An active approach is not synonymous with superior performance. In fact, any outperformance of some active investors must be offset by the underperformance of all other active investors.

Many active investors believe that it is naive not to try to “beat the market.” Either they don’t understand that active management is a zero sum game or, unrealistically, they all think they are better than the average investor!

And let’s not forget the certain losses you will incur as a result of the added costs of being an active investor. In general, compared to passive investing, they include higher transaction and management costs, early capital gains tax crystallization, and reduced diversification benefits.

What level of superior performance is required to justify this continued drag? Over a 30-year period of investing in the stock market, our estimate is that you would need to generate an additional (risk-adjusted) return of at least 2% per year just to break even with a passive investing approach. You need to be fairly confident (perhaps too confident) in your investment skills to take this “Alpha” bet!